FTSE Global Markets

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EXPANDING INVESTABLE HEDGE FUND INDICES I S S U E O N E • M AY / J U N E 2 0 0 4

DIMON STANDS TO

DELIVER

Will ETFs have enough bite for investors in China?

BGI’s iShares sharpen their appeal

EUROPE GAMBLES ON A BIGGER FUTURE

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Outlook EDITORIAL DIRECTOR:

Francesca Carnevale, Tel + 44 [0] 20 7074 0008, email: francesca@berlinguer.com CONTRIBUTORS:

Bill Stoneman, David Simons, Rosalyn Retkwa, Ian Williams, Neil O’Hara, Art Detman, Martyn Cherrin, David Burrows, Andrew Cavanagh, Stephen Hannah, Tobias Webb, Angela May Ward FTSE EDITORIAL BOARD:

Mark Makepeace [CEO], Peter de Graaf, Paul Hoff, Jerry Moskowitz, Paul McLean, Stuart Ives, Marianne Huve-Allard, Sandra Steel, Carl Beckley SALES DIRECTOR:

Paul Spendiff OVERSEAS REPRESENTATION:

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Air Business Ltd, 4 The Merlin Centre, Acrewood Way, St.Albans, Herts. AL4 OJY FTSE Global Markets is published six times a year. No part of this publication may be reproduced or used in any form of advertising without prior permission of FTSE International Limited or Berlinguer Ltd. FTSE Global Markets is published by Berlinguer Ltd on behalf of FTSE International Limited .

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FTSE™ is a trade mark of the London Stock Exchange plc and the Financial Times Limited and is used by FTSE International Limited under licence.

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The articles are commissioned independently from FTSE International Limited and represent only the ideas and opinions of the contributing writers and editors.

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elcome to this debut edition of FTSE Global Markets. Every two months the magazine will provide you with important insights into the trends, institutions, companies and exchanges that operate in tandem to create the pulse in the international financial markets. Our intention is to provide you with the very best in comment and analysis on equity and debt markets around the world.

As deal flow improves and benchmark data becomes more widespread and varied, the publication of a comprehensive analytical title is a valuable tool for market makers. FTSE Global Markets brings together the key trends and personalities in the international financial markets and gives meaning to their actions – outside of the day-to-day market fluctuations and deal flow. It has relevance for issuers and investors alike.

The magazine will be delivered to some 20,000 issuers, fund managers, pension plan sponsors, investment bankers, brokers, consultants, stock exchanges and specialist data providers.

One of the dominant themes covered in this issue is the prospects and problems attendant with the incorporation of 10 new members into the European Union. A complex pattern of new alliances and strategies will likely evolve that will have an enormous impact on the European financial markets over the coming decade. Market and political strategies will emerge, at both national and regional level. We look at the impact on individual country strategies: offering surveys of countries already established in the Union, such as Greece; and those still awaiting accession, namely Turkey. We also take the opportunity to examine the effect of closer union on the back office, and the problems of developing a cohesive European-wide clearing system.

Bill Stoneman, meanwhile, analyses the impact of the impending merger between Bank One and JP Morgan Chase. The merger is a bellwether of the changes affecting the American banking system, which has undergone a period of extensive consolidation while not necessarily creating shareholder value. Both sides of this deal are themselves products of relatively recent mergers which have not precisely delivered on their promises. Will the mega-merger break the mould?

In each issue the magazine will offer you coverage of as many markets as possible. In the upcoming issue, due in July, you will read about CalPERs’ new investment focus; how the US banking and mutual fund markets are coping with a series of investment scandals, and special reports on the Nordic region, Africa and North American markets.

Moreover, the second edition will include a survey on Global Custody. As well, we will review the upcoming developments in corporate governance indices, FTSE Hedge index performance, and industry classification.

If you would like to comment on any of the articles please write to me at francesca@berlinguer.com or phone me on 020 7074 0008. Thank you for your kind attention and I hope you enjoy reading this issue.

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Francesca Carnevale, Editorial Director, April 2004

Subscription Price: £399 per annum [6 issues]

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Contents COVER STORY IT’S THE DELIVERY THAT COUNTS ............................................Page 20 James Dimon is CEO-in-waiting when JP Morgan Chase & Co’s acquisition of Bank One Corp is finalised and much is expected of him. However, mega-mergers are notoriously difficult to handle and few have provided shareholder value. Will James Dimon bloom in his new role; or will he find a few thorns along the way?

REGULARS NEWS

BMA issues new guidelines ..........................................................................................Page 11 AIM rides high ....................................................................................................................Page 11 IASB issues hedging amendments ..............................................................................Page 12

REGIONAL REVIEW

High Noon as NASDAQ squares up on dual listings ..............................................Page 14 Caravan I rewrites Islamic Finance ............................................................................Page 16 FTSEurofirst comes of age ............................................................................................Page 19

INVESTORS SEARCH FOR ALPHA

EQUITY REPORT

................................................Page 33 Rosalyn Retkwa explains the rise of currency overlays

DO OFFSHORE EXCHANGES HAVE A FUTURE? ..........Page 36 Why recognition means more competition

DEBT REPORT

THE EXPANDING WORLD OF COVERED BONDS ........Page 58 Germany exports pfandbriefe

THE APPEAL OF SMALL CAP INDICES ....................................Page 73 ALTERNATIVES

Are small cap indices a proxy for private equity investing?

STRIKE OUT

..........................................................................................................Page 76 SEC pitches a curve ball to US hedge funds

RESPONSIBLE COMPANIES CAN WIN OUT ........................Page 70 OPINION

Tobias Webb says the good guys don’t always come last

IS DEFLATION OUT-DATED?

..............................................................Page 79 Why you should worry about inflation instead

EXPANDING INVESTABLE HEDGE FUND INDICES

INDEX REVIEW

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......Page 82 Market Reports by FTSE Research ..............................................................................Page 86 Provisional Country Classification Criteria ..............................................................Page 92 Calendar ..........................................................................................................................Page 96

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FEATURES EUROPE GAMBLES ON A BIGGER FUTURE ......................Page 39 On the eve of accession Europe shows its nerves The Myriad Faces of a New Greece ............................................................................Page 46 Why Turkey is trying hard to be noticed....................................................................Page 53 OYAK eyes the global markets ....................................................................................Page 56

GLOBAL CLASSIFICATION Q & A

....................................................Page 4 Will there ever be a single, universally-accepted global country classification system?

Not everyone thinks so. This Q&A highlights the methodology, results and questions arising from the latest country classification initiative.

WHY INVESTORS SHOULD LOVE ETFs

....................................Page 25 China is considering opening its market to open-ended exchange-traded funds. ETFs combine the advantages of both open and closed end funds, say Zhu Shan and Luo Yinghao explaining how investors can benefit from them.

iSHARES SHARPEN THEIR APPEAL

..............................................Page 30 iShares – exchange-traded funds that combine index-fund style diversification and the liquidity of stock trading – are making a comeback. David Simons talks to Lee Kranefuss who explains why they are enjoying a resurgence.

WILL TECH STOCKS MOVE ON TO BETTER TIMES?

....Page 63 Tech stocks began a steep climb late last year only to fall again. Why do investors replay the tech stocks game again and again? Ian Williams reports from New York on the investors who still love tech stocks despite the evidence against them.

WHY SETTLEMENT SITS AT SEPARATE TABLES

................Page 66 Will Europe ever get a centralised securities depository? David Burrows explains why a merger between Euroclear and Clearstream is as far away as it ever was.

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FTSE Group has unveiled the results of its public consultation on the treatment of countries within global benchmarks.

In an increasingly competitive market for assets, the delineation of a single standard to assess the market status of countries for investors is imperative.

In a special Q&A feature, David Hobbs, head of Passive Investment at UBS and chairman of the Classification Review Group, Ali Toutounchi, deputy managing director, Index Funds at Legal & General Investment Management and Graham Colbourne, director, FTSE Group consider the questions.

N A PRECURSOR to what may be a seminal step towards the creation of a universal global country classification system, FTSE group has now published the results of an international consultation exercise. From September 2004 FTSE will apply the new framework and conduct an annual review of the status of countries under the classification system. Individual countries will be clearly delineated as either developed, advanced emerging or secondary emerging.“FTSE Group is seeking to establish a transparent and widely accepted approach to treating countries in global indices – as there is no single, widely used and transparent way of treating markets,” says Graham Colbourne. [See Box: How current country categorisations differ].

Just over 100 leading investment institutions throughout the world were included in the consultation process. A number of important landmark decisions can now be applied from the results. FTSE has also produced a provisional Watch List of two important and possible changes to country classification within the FTSE Global Index Series – namely the possible reclassification of Taiwan and South Korea, and also the inclusion of China A Shares.

Attendant with these announcements however, a decision has been made that the FTSE Global Equity Index Series will continue in its current form and will be unaffected by any changes in the reclassification of advanced emerging countries, at least for twelve months.

A further provisional assessment of the quality of markets for both developed and emerging markets has been issued. FTSE will use economic wealth and quality of markets as its two main measures to assess the status of markets in its global indices.

In a special development, new shadow indices will come into play for Asia Pacific and emerging

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Until now, FTSE has followed a markets. Shadow indices are relatively informal process in its indicative tools to enable investors classification of countries, but the to prepare for these changes within criteria have now been crystallised. the FTSE Global Equity Index Series.

How important was that process – The shadow indices will come into and if important, why did it take so play in March 2005 and will include long for everyone to get to this point?

China A shares and the Graham Colbourne [GC]: It is reclassification of Korea and Taiwan not easy to move from subjective to as developed markets. Until now, objective criteria. Subjective criteria FTSE has followed a relatively can hide a multitude of sins, but also informal process in its classification ensure the ‘right’answer is produced. of countries, but the criteria have Objective criteria can sometimes now been crystallised. “In recent produce some unpleasant surprises – years, the feeling has grown that normally because the wrong there should be an objective question has been asked. It took assessment of the factors which quite a while to agree the right distinguish between developed and questions and then research the emerging markets, in the same way answers on a global scale. that the eligibility of individual Ali Toutounchi [AT]: It is stocks is assessed. This has been David Hobbs, head of passive investment at UBS absolutely important to make the partly driven by consideration of a and chairman of the Classicifaction Review Group indices more transparent. Using this number of countries in Asia, which have been mooted as due for promotion to developed status. approach made it more transparent, and the reason it was Since this has involved taking market analysis into new not done before is that it is not an easy process, particularly ground, the gestation has taken some time,” says David in emerging markets, where you have to marry objective and subjective criteria.

Hobbs, head of Passive Investment at UBS. The move towards the establishment of an individual, globally recognised system of country classification has been What, in your judgement, were the most important results or findings of the consultation process among international gaining momentum over the last year.

This is paralleled by similar developments at the investors?

David Hobbs [DH]: That, in addition to market size, corporate and sector levels too. In February this year, Dow Jones Indexes and FTSE Group signed a Memorandum of there is general agreement that market regulation and Understanding that governs the merger of their respective governance are important factors in distinguishing industry classification systems to create a single, seamless between developed and emerging markets.

GC: The consultation exercise generally supported the structure covering both equities and corporate bonds throughout the world. The new system will come into effect structure FTSE had proposed and the Gross National at the end of 2004 and is called the Industry Classification Income [GNI] data and quality of markets estimates Benchmark [ICB] and will cover some 50,000 companies broadly supported the current allocation of countries to worldwide. It is expected to become an industry standard. developed, emerging and secondary emerging. There are a ICB will be transparent and rules-based. A special advisory few issues at the country level, but no big surprises. Perhaps committee of market experts will guide both Dow Jones the most pleasing feedback was the wide acceptance of the and FTSE on the development of ICB and – from time to concept and the positive attitude of countries which ‘need to do better’. time – on individual stocks.

How current country categorisations differ

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Country/Index Provider

FTSE

MSCI

S&P Citigroup

Czech Republic Hungary Iceland Jordan Nigeria Slovenia South Korea Venezuela

Emerging Emerging Not eligible Not eligible Not eligible Not eligible Advanced Emerging Removed in 2003

Emerging Emerging Not in global index Emerging Not in global index Not in global index Emerging Emerging

Developed Developed Developed Emerging Emerging Developed Developed Emerging

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SUMMARY RESULTS OF THE CONSULTATION

O

ver 100 investment organisations from 30 countries worldwide responded to the consultation paper.

- 84% of respondents believe there is insufficient clarity in the way global benchmark indices define the market status of countries today; - 74% want the eligibility of countries to be determined using more objective criteria; - 93% want the quality of markets taken into account; - 57% felt that dividing emerging countries into ‘advanced emerging’ and ‘secondary emerging’ is useful; - 90% felt corporate governance practices within a country are important in determining its market status; - 86% supported FTSE's proposed criteria and approach to promoting and demoting countries between ‘developed’ and ‘emerging’ categories; - 79% of respondents supported the proposed Watch List of countries setting out possible future changes.

Were there any surprises?

DH: Some developed markets do not score highly on regulatory issues.

AT: I was surprised to see that the majority of respondents thought that the advanced emerging classification was useful, because I don’t. It just creates a grey area in my view and creates practical problems for fund managers.

How do you judge initial reactions to the new global classification structure?

DH: Generally favourable, although for many global investors these are not hugely significant issues. The Asia Pacific regional view is slightly different from elsewhere, because investors there find difficulty in distinguishing between Hong Kong, which is a developed market, and Taiwan and Korea, which are not.

GC: Very positive. It seems as though FTSE will, again, be setting new standards.

AT: Informally, people are in favour of the steps that FTSE have taken.

FTSE has decided not to make any changes to any one country’s status this year – but it has announced a provisional Watch List of possible changes to country classification within the FTSE Global Equity Index Series. Only two countries are in line to move from ‘advanced emerging’ status to ‘developed’ next year: Korea and Taiwan. So few?

DH: Taking economic, political and governance factors all into account, there aren’t many countries which stand out as ready for promotion. Korea and Taiwan are the leading candidates, but even these countries need to make significant improvements to their market practices in order to meet the new standards required for developed market status.

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GC: I think this is a testament to the quality of the previous subjective criteria. The main problem with the previous criteria was not that they produced the wrong result, but rather that they were not transparent for investors. But as well, countries often did not know why they were classified in a particular way or what they needed to do to enhance their classification.

AT: Even in terms of Taiwan and Korea there are conditions that are not yet satisfied. In all other aspects they do, but there are important ones they fail on. As things stand they don’t qualify and so the authorities in Taiwan and Korea have to look at them seriously if they wish to be promoted.

74% of investors want the eligibility of countries to be determined using more objective criteria. How successful do you think the new classification standards are in this respect?

DH: There appears to be a high level of support for the proposed standards.

FTSE plans to conduct a review of all emerging markets in September 2004 at which point countries will be assigned to an Advanced Emerging or Secondary Emerging category. Why revisit this? What will, if anything, change between now and then?

DH: Although the country review has been as thorough as possible in the available time, the six month period up to September allows for the provisional ratings to be reviewed further and for market authorities to make changes which may affect the future status of their countries.

AT: The main reason is consistency across the board which is important for the integrity of the index.

How likely is it that sufficient changes or alterations will take place within those countries to qualify them to move up rankings?

DH: This is difficult to say. It all depends on the willingness of the markets to listen to investors’ views and take the appropriate action.

Even if a change is to take place, then the country would have to wait for six months longer – so really are we saying no change for a year?

DH: We are saying no change for at least a year. This is because some countries need to make changes to their market practices in order to confirm their provisional classification and because investors need to have sufficient time in which to execute any necessary changes to their investment policy so as to minimise market impact.

Does the term “advanced emerging market” really have any meaning – other than to the countries who might be disappointed at not achieving developed market status?

DH: My view on this has changed as a result of the review. I now believe that this intermediate status represents a useful stepping-stone in the progression from emerging to developed status, in terms of both economic and market evolution.

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Can a country ever really escape the ‘trap’ of being labelled an Some 86% of investors polled in the consultation phase ‘emerging market’? Do you, for example, think that Greece, supported FTSE’s approach to promoting and demoting countries between ‘developed’ and ‘emerging’ categories. Are Portugal, Spain, have succeeded? Are there many more?

DH: In many respects, the answer to this question lies in we going to see the emergence of country league tables, with the hands of the markets themselves. If countries continue countries being demoted and promoted on a regular basis?

AT: I don’t think this will to employ practices which happen. Competition is the restrict access to the market by essence in a football league. This international investors, they is not the intention here. Where may well retain an “emerging” countries stand in the league is to label, but otherwise there is no some extent out of their control; reason why they cannot enjoy for instance, how big they are and the benefits of “developed” what contribution they make to status in terms of investor flows the international economy. But and market valuations. One there is no competition. One current challenge is for the country coming up does not leading countries newly joining knock another one down. Each the EU from Eastern Europe to market should, however, focus on make the necessary changes as what they need to do to be rapidly as possible. promoted and ensure that once GC: The answer clearly is yes, promoted they stay there. because Portugal and Greece have and Iceland probably will Do you envision country and we’re suggesting that South classification becoming more or Korea and Taiwan can make this less complex? transition as well.

DH: I hope that it will AT: Again this is the beauty of become less complex over time making the process more but this depends on market objective. If they satisfy the evolution. conditions laid down they can GC: It will become more remove the label from their Graham Colbourne, director, FTSE Group complex as we consider more forehead. They know what they need to do to be promoted and hence attract more foreign factors. If you look just at one issue, such as economic investment. I think this will be appreciated by the wealth, it is misleading. By definition, when you look at more factors, such as the quality of markets, it becomes more authorities in these markets. complicated. But the assessment is more accurate and useful.

AT: I don’t think so; I think it becomes more transparent, Are there comparable criteria – for example, country ratings from ratings agencies such as Moody’s or Standard and which is the main object of this exercise. From an investor’s Poor’s [S&P] – which could serve as a proxy for market risk? point of view, we don’t like to see countries coming in and out frequently.

Were and should those ratings be considered?

DH: Possibly. But the setting of these ratings is not very transparent and the ratings themselves are subject to Is there a ‘political risk’ element in the classification criteria? regular adjustment in reaction to market events. The I’m thinking of potential political instability in Taiwan; objective of the FTSE classification is to produce stable actual instability in Israel; potential destabilisation in other ratings which will change only infrequently and in a largely markets vulnerable to terrorism over the medium-term.

DH: Yes. Political and economic risks are factors which predictable manner.

GC: This is a thorny question. Israel obviously raises are likely to influence classification decisions since stability these kinds of issues. But I don’t think that what we are is one of the key dynamics in assessing market status. doing is comparable with S&P and Moody’s ratings. I don’t think we are in that bracket and it’s not what we are trying How flexible/negotiable are the criteria?

DH: This is a new process so it is unlikely that FTSE has to achieve.

AT: The aim of the working party has been to come up got all the criteria precisely right at present. There therefore with a set of appropriate and stable criteria which cover all needs to be some flexibility in matters of detail as long as important aspects of defining a country’s classification. This the principles remain inviolate.

GC: Although the criteria are fixed, they may evolve over list is quite comprehensive and is bound to be fine-tuned in the course of time to make them even more transparent time. The assessment of the criteria, for each country, will as the indices evolve. Therefore I’m not sure of the benefit require some interpretation, but FTSE plans to apply the criteria consistently. of using data from credit agencies.

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GLOBAL CLASSIFICATION

FTSE also announced that Shadow Indices would be introduced for Asia Pacific and emerging markets in March 2005 which will include eligible China A shares (currently only available to international investors through the Qualified Foreign Institutional Investors Scheme). What does this mean? How will it work? What is trying to be achieved? Did investors ask for this? Will there be significant pick up of Shadow Indices?

GC: FTSE is conscious that different investors take different approaches to the Chinese market. We want to present a wide range of indices to them so that they can adopt a wide range of strategies and in a timely fashion.

Is there a measurable increase in inward investor flows to markets on Watch Lists? Is there an ‘upgrade premium’? Or, are other factors also at work?

DH: There should be a measurable impact on market valuation as countries move from emerging to developed status, but this will tend to be evolutionary in character.

FTSE’s process of putting countries onto a Watch list and giving an extended notice period of any status change is intended to reduce the frictional impact of such changes.

AT: A typical pension fund has 3% to 5% of total assets in emerging markets, the amount allocated to developed markets is many times that.

How are FTSE’s competitors reacting to the announced changes? Any feedback to date? Obviously FTSE’s classification is used by Dow Jones and Russell. MSCI is known also to be thinking of upgrading Taiwan and Korea.

With that kind of common thinking, shouldn’t everyone work to developing just one set of classification benchmarks?

GC: No-one’s done anything yet. In most areas like this FTSE is leading. We think it will force them to review their criteria. S&P, which now owns the Salomon Indices, use a single factor for determining status, which is economic wealth. What this does, for example, is classify the Czech Republic and Slovenia as developed markets. The market doesn’t necessarily think this is the right answer. MSCI will also be pressured to be more transparent in terms of their criteria.

A large number of respondents in the consultation period felt that corporate governance within a country was an important element in determining market status. Is that realistic – given that corporate scandals appear equally in both highly sophisticated markets, which are governed by a plurality of regulatory authorities and laws, and unsophisticated markets in which regulation still leaves much to be desired?

DH: This is an interesting question. I think that the checks and balances are typically stronger within developed markets, which is not to say that scandals cannot arise. In these markets, however, scandal tends to result in stronger regulation thereafter viz. Sarbanes-Oxley whereas, in less sophisticated markets, many investors feel that poor practices seem to be endemic and remain largely unchecked.

10

AT: You cannot eliminate corporate scandals, but you can do things to minimise the risk and there are things we can do to ensure that all shareholders are treated equally. The corporate governance issue is more important for that reason. Again, it’s important but difficult to quantify. All you can do is to come up with ways to encourage countries to improve their corporate governance records.

Can you realistically see a country such as the US’s country status being affected despite the emergence of other Enrons and WorldComs? Or, are investors really saying that these are standards by which a singular group of countries should be measured: for example: Russia, Turkey and Brazil?

DH: My answer to this is the same as that given above.

Asia, at first glance seems to be benefiting from the refit in classification standards. What are the prospects for other advanced emerging markets, such as Brazil, South Africa, Israel and Mexico? They can’t be too happy at the moment – or are they?

DH: The status of all countries will be reviewed in the context of the new classification guidelines. No decisions on the status of individual countries will be taken before September at the earliest.

AT: The guidelines ensure that all countries are reviewed on the same basis. In addition, they highlight what each country needs to do if it wishes to qualify as a ‘developed’ market. This is as fair as one can be.

How do corporate governance ratings for ‘developed’ and ‘emerging’ markets fit into the complex of classification?

DH: Corporate governance will be one of the key features of the Quality of Markets assessment in determining market status. The new FTSE-ISS corporate governance ratings are expected to be completed for ‘developed’ markets by the end of 2004 and for ‘emerging’ markets during 2005. This will allow corporate governance to be included in the formal assessment matrix in about 12 months’ time.

Are we moving to a globally accepted benchmark or standard for country classification? Is this the dream?

DH: This is the objective but remember that standards will change over time so what is acceptable practice now may become unacceptable at some point in the future. We hope that the setting of objective criteria for market classification will lead to an evolutionary improvement in global standards generally.

AT: I think it is a big step towards it. Hopefully that will emerge. However we need to be realistic and in the end, bearing in mind the competition between index compilers, it is difficult to assume that we will have a single, universally accepted method.

Please refer to pages 92-95 for the provisional country claffification criteria.

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In the Markets BMA issues new debt guidelines MIDDLE EAST – THE BAHRAIN MONETARY Agency (BMA) has issued comprehensive guidelines for the issuance, offering and listing of debt securities.

The rules will encourage broader use of debt securities. The BMA is easing the rules governing the offering and listing requirements, but it is strengthening measures to protect the interests of debt-holders. The guidelines cover in detail the issuance, offering, listing and ongoing obligations in structures , as well as the

requirements for offer prospectuses.

The new guidelines, are based on existing applicable laws and regulations, particularly the extant Commercial Companies Law and the Bahrain Stock Exchange Law, as well as international best practice.

The rules lay down clear and definite requirements and basic conditions for issuers as well as for each class of debt securities, such as Islamic private debt securities; asset-backed securities; convertible debt securities; debt securities issued by states, state

corporations and supranationals; securities issued by banks and financial institutions and by overseas issuers.

The move is seen as important, particularly by leading securitisation professionals in the region, which has recently seen debut securitisation deals based on Shariah principles.

The BMA is now in the process of developing guidelines on the function of primary dealers and the role of trustee as a debt-holder’s representative, which will enable financial institutions to play a major role.

New record set for AIM’s Q1 IPOs

[compared with 156m in 2000 and 227m in 2003] with an average daily value of £82m, compared with £26m last year. “A renewed sense of buoyancy and optimism coupled with the fact that the market is now larger have contributed to AIM reaching record trading levels”, said Secrett.

AIM’s hopes of becoming more international are also coming to fruitition. So far this year nine foreign companies have joined – about half the number of firms that listed last year.

The introduction of fast track admission rules have helped.

In March, Gippsland Limited, an exploration company listed on the Australian Stock Exchange [ASX] was the first ASX company to take advantage of the fast track admission rules.

“Given two successive quarters of impressive results and the awareness of sustained activity levels in the pipeline, the outlook for the rest of the year is extremely encouraging,” says Secrett. The bumper levels of activity that the market is currently enjoying also look much more stable than they did in 2000, he adds.

While the dotcom boom was primarily technology led, the current

wave of activity is the result of more evenly spread success stories. Mining and exploration companies are undoubtedly playing a central role in helping achieve further growth; however, overall activity levels have their roots in many more sectors.

“Provided that 2004 remains free of major destabilising economic and political factors, the opportunity for companies to raise funds and achieve valuation expectations through an AIM flotation will continue”, concludes Grant Thornton’s Secrett.

EUROPE – RECORD TRADING LEVELS in the UK’s alternative investment market [AIM] could be a positive indicator of better times ahead.

"The first quarter of 2004 has seen the AIM market return to the booming levels of activity last seen in 2000 during the dotcom boom," says Philip Secrett, a partner at Grant Thornton Corporate Finance.

During Q1 2004, AIM reports a 140% increase in IPOs, up from 22 during Q1 last year to 54 this year. Fundraising activity also returned to bumper levels with new money raised on AIM totalling £492m – a 22-fold increase on Q1 last year, representing almost 45% of new issues money raised during the whole of 2003. The largest issue to date, in March, by publishing company Centaur Holding plc raised over £130m.

The average daily volume and value of shares traded on AIM also reached record levels. During January and February this year, an average of 485m shares were traded on a daily basis

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FTSE on TIMS EUROPE – FTSE INDICES ARE now available on TIMS the index management service. TIMS itself was launched in February by Dividend Directory Limited, a subsidiary of US firm Totem Market Valuations. The indices on TIMS are provided by the index producers rather than third parties and the addition of more than 60,000 FTSE indices now means that TIMS users can now access virtually any commercially available index or ETF through one data source.

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In the Markets IASB issue hedging amendments UNITED STATES – THE INTERNATIONAL ACCOUNTING Standards Board (IASB) has issued an Amendment to IAS 39 Financial Instruments: Recognition and Measurement on Fair Value Hedge Accounting for a Portfolio Hedge of Interest Rate Risk. The amendments simplify the implementation of IAS 39 by enabling fair value hedge accounting to be used more readily for a portfolio hedge of interest rate risk [sometimes referred to as a macro hedge] than under previous versions of IAS 39.

The amendment was made following concerns expressed by the banking community about the potential

difficulty of implementing the requirements of IAS 39. Many constituents had sought fair value hedge accounting treatment for portfolio hedging strategies, which was not previously permitted under IAS 39.

Although IAS 39 will become mandatory around the world [excluding the US] from 1 January 2005, it is itself under review and will eventually be replaced. In the meantime, despite being considered more lenient that the equivalent rules in the US, there have been complaints, particularly in Europe, that disclosing interest-rate swap books in their accounts will lead to confusion amongst investors.

MEPs reject mandatory quarterly reporting, but insist on pay disclosure EUROPE – THE ECONOMIC AFFAIRS Committee tasked with finalising the transparency requirements directive rejected a clause providing for mandatory quarterly reporting by share-trading companies.

The committee removed Article 6 of the directive, which requires all issuers of shares admitted to trading on a regulated market to disclose financial information on a quarterly basis. The committee of MEPs decided that this would impose an unnecessary burden on companies and encourages management to focus on short-term profitability. They concluded that what investors value above all is the provision of quality information when it is available rather than mere frequency of provision of information.

Under the Commission proposal, companies' annual financial reports will include the audited financial statements, the management report and, in line with existing company law, statements by persons responsible for such information.

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MEPs did vote overwhelmingly for annual reports to include information on remuneration and benefits granted to members of the management and supervisory bodies, senior management and key personnel.

The Committee agreed with Commission proposals to extend the obligation of halfyearly reporting for issuers of debt securities as long as there is an exemption for small issuers. There is already an agreement with Council not to impose these obligations on issuers of high denomination bonds, in particular Eurobonds. Currently, EU law requires half-yearly reports only for issuers of shares, whereas issuers of debt securities are not subject to any interim reporting requirements.

The directive, which is likely to become law before the end of June, is part of the Financial Services Action Plan agreed at the Lisbon summit, which aims to harmonise disclosure requirements for companies trading in regulated markets.

Japanese banks up 250% ASIA – THE STOCK MARKET capitalisation of Japan's banking sector has increased by just 250% a year according to the FTSE Japan Bank Index (Large/Mid cap).

Japanese banks saw some of the steepest falls in 2002 and those that suffered most are showing some of the biggest rebounds.

Although much of the increase can be attributed to gains on the Tokyo Exchange, which posted two year highs at the beginning of April, financial reform and improving economy and a reduction in the number of non-performing loans that have dogged the sector have enabled the banking sector to outperform the market.

Resona Holdings, one of the largest of the 40 institutions which make up the index, saw its market capitalisation increase more than six times over the last 12-month period following the government's infusion of public funds into the group.

Market commentators, however, think future gains in the banking sector will be more modest and that future share price increases will depend on restructuring of loan portfolios, productivity gains and further consolidation in the sector.

Reed to stay on at NYSE UNITED STATES – JOHN REED HAS agreed to stay on as chairman of the New York Stock Exchange [NYSE] until April 2005, in part due to the difficulty the NYSE has met in finding a suitable permanent replacement. Reed was appointed for one year, replacing Richard Grasso who was forced to stand down following controversy over remuneration payments totalling some US$139.5m. It has been widely reported that Reed had approached Grasso earlier this year in an attempt to get some of the monies returned. However the matter looks set for the courts and, until a resolution is reached, is likely to further complicate the search for a new chairman.

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Regional Review UNITED STATES

HIGH NOON IN NEW YORK In the fight for market share NASDAQ is promoting dual listing opportunities to NYSE blue chip stocks. After only a few months, dual listing is looking more and more like a duel between the lists. Ian Williams in New York reports on the bun-fight developing between NASDAQ and the NYSE. ASDAQ’s CHIEF ECONOMIST Frank Hatheway makes little secret of the eventual aim of its experiment with dual listing for some NYSE companies.“We hope that if they find the environment congenial they will shift over, but otherwise we’ll be happy to let them stay dual listed.

Competition is good.”

NASDAQ announced the pilot programme in January, allowing six NYSE blue chip stocks, Apache, Cadence Design Systems, Charles Schwab, Countrywide Financial, HewlettPackard, and Walgreens to also list with NASDAQ for a year at no charge.

Hatheway traced the history back to 2000, when the SEC mandated that Market Centers report what their trades were like for market quality. “The data was available in 2002, and for S&P 500 stocks, speed was faster, and cost was lower on NASDAQ than on NYSE. So we began to talk to issuers in 2003. We

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were going ahead anyway, but then NYSE began to have problems. And that certainly didn’t hurt our effort.”

The problems that Hatheway refers to are, in fact, SEC investigations into the role of the seven specialist firms on NYSE that make markets in the stocks listed there and, of course, the controversy over governance issues such as former chairman Richard Grasso’s salary. NASDAQ is happy to pour salt in the wounds.

Neither NYSE nor the specialists tried to pressure would-be dual listers out of their plans, and publicly they welcomed the competition. They reserve their contumely for NASDAQ itself, albeit mostly privately. One NYSE specialist partner, who preferred anonymity, riposted, almost through gritted teeth,“If NASDAQ is so interested in competition, why did they say they would drop any company from the “QQQ: NASDAQ 100 index if they listed

with NYSE?” he asked, only to answer himself with audible bitterness, “NASDAQ is fighting for market share.

The ECNs are eroding market share in NASDAQ, dual listing is a no-cost way for them to try to capture market share.”

The specialist partner concludes that “We have a system on NYSE which works with very few market makers.

Over 80% of the time, a public buyer meets public seller and in the end we get 99.8% of all trades executed in under 15 seconds.” He declares: “dual listing hasn’t been effective. It hasn’t eroded market share away from New York.”

While NASDAQ compares its 300plus broker dealers who make a market in its stocks, with the seven specialists, a NYSE spokesman eager to tarnish its rival’s recently donned halo, churlishly pointed out that this was not an unmitigated blessing – the SEC levied penalties of $26m on some of those 300 in 1999.

While a few seconds delay here or there may not make much difference, particularly as their trading methods converge, the dual listing does offer some hopes of tangible advantages, although yet unproven, both for investors and listed companies.

For institutions, such as the redoubtable CalPERS, which is calling for trading reforms, NASDAQ’s Hatheway points out that they want major movements of stock to remain “invisible,” which is difficult if you have to work through a specialist. “When you have to go to a single human being, you create that risk.”He qualifies the statement: “I’m not saying that specialists do that by any means, but the risk is there. An institution can come into NASDAQ to trade and remain invisible to the specialist, whether they are posting liquidity to or taking it from NASDAQ.” Pilot companies such as Countrywide Financial, the mortgage lender, see

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opportunity for greater access to investors through NASDAQ’s network of dealers. David Bigelow, its managing director for corporate development and investor relations, explains their participation in the dual listing pilot,“as something that we thought may benefit our stock and shareholders, so it was worth trying on a test basis.”

However, he says,“It’s not something that I expected a lot of impact from right away.” For the experiment to be successful, he suggests,“there would be evidence of greater liquidity in the stock as their market makers begin to participate more actively in trading our stock. It would create greater liquidity, more efficient trading, the stock would be getting traded in places that it wouldn’t have otherwise.” And, he points out, that while they were more concerned about the overall impact, “Having better retail exposure is one of our longer term strategies,” which is something that the NASDAQ’s dealers claim as an asset.

Bigelow admits that “the one thing we saw as a potential risk was that we might damage the good relationships we have with the NYSE and our specialist, but we felt we would just try to manage it, and that the benefits would offset the risk.”Luckily he reports that although they “were obviously disappointed and probably preferred that we do not do this, they have been very positive and pro-active, and they would like to convince us back.”

In the end, he estimates success for Countrywide is to see more trading off NYSE, without diminishing the 80% currently traded there in absolute terms, and both exchanges have committed themselves to providing data on the experiment.

Hatheway of NASDAQ agrees that the experiment is too early to assess, and adds that the exchange is integrating its trading platforms so that traders no longer have to use separate systems for

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trading its own stock and NYSE stocks.

“Now they can use the same platform for any stock, we think we have removed the barrier that may have existed for some firms, at least in their tech costs.

That environment is going to draw people into the NASDAQ environment.”

Our unnamed NYSE specialist disagrees,“Order flow gets sent to New York because it’s the lowest cost place,” he says, pointing out the caps on fees there. “I don’t see dual listing will be effective competitively for the NASDAQ – it will just cost investors more.

The NYSE also regards the whole issue as “basically a marketing ploy by NASDAQ, not really offering anything new in terms of the business, and the benefits to either the investor or the listed company. They already have the right to trade NYSE listed companies. In reality 20% of our listed companies’ stock is traded on other markets …

We think the dual listings will lead to fragmented trading and disruption of opening and closing prices, and a whole list of other disadvantages, such as bifurcated trading. And they will confuse corporate government standards.”

And the spokesman also points out the fundamentals as seen by NYSE, “Since 1990 680 companies have transferred from NASDAQ to the NYSE, and only one company voluntarily moved the other way.”

NYSE also refers to the greater volatility of NASDAQ but Hatheway points out that the volatility relates to the sector and not the market they are listed on. NASDAQ has 700 banks and financial institutions listed, as well as companies like Staples, Costco and Starbucks, “When you compare like companies with like, NASDAQ comes out quite well on volatility.”

Apart from a family bun fight on Wall Street, what does this mean for overseas companies? Well both exchanges are eagerly pursuing their listings. Peter Yandle, senior managing

director, international marketing, at NASDAQ says: “We see dual listing as the same as bringing companies to market for the first time, and indeed for international companies, we see secondary listings as being a critical part of our business development.”

The additional costs would be minimal, he explains, since the main cost for foreign companies is conforming to US GAAP and Sarbanes-Oxley, which they would have to do whichever exchange they list on. As for the actual effect of a dual listing – the jury will be out until the end of the year. But as Yandle points out, some companies like the idea of an American listing as a certificate of good conduct – so a dual listing would be a double endorsement!

CBOT announces record volumes OR THOSE INVESTORS keen on commodities, a rare combination of shortages and simultaneous increases in global demand for grain and oilseed has buoyed both trading and the prices of CBOT’s agricultural products to historic levels. CBOT Soybean futures and options, in particular, have seen brisk trading activity, with price levels hitting double digits, a phenomenon unseen since the drought-ridden summer of 1988.

With trading volumes in March registering at almost 50% higher than March 2003, CBOT reached a record 51.5m contracts in the month. CBOT chairman Charles P Carey, notes significant growth in volume and open interest in all the exchange’s core product areas: commodities, financials and equities. A highlight in March were Ten Year Treasury Note futures – which set a daily trading volume of 1.3m contracts.

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Regional Review MIDDLE EAST

Caravan I opens up Islamic financing Investors take note. Islamic financing is breaking out of its bounds. Two ground breaking securitisation deals in the Middle East in quick succession could open the door to significant foreign investor interest in Islamic financing structures. n March Volaw Trust Company, Voisin & Co and Bemo Securitisation SAL [BSEC] finalised a ground-breaking three year Saudi Riyal 103m securitisation deal which could rapidly multiply investment in Islamic financing. The so-called Caravan I deal is backed by a pool of motor vehicles that are subject to Ijarah lease agreements, sold by Hanco Renta-car, a leading Saudi Arabian car rental and leasing company.

Caravan I follows the Kuwaiti Dinar 5.3m [$18.7m] securitisation [or Tawreek] by Al Manar Financing & Leasing of Kuwait of Investment Dar’s – a Kuwaiti Islamic investment company’s – retail finance account receivables by Al Manar in December 2003. Al Manar purchased the retail portfolio of some 1,000 clients from Investment Dar. The deals are different in many respects, not least Caravan I is based on future lease payments, while the Investment Dar structure is based on debt obligations. That raises some interesting questions: “I’m intrigued about the Shariah advice they [Al Manar] received,” says Robert Christensen, managing director of Volaw Trust and Corporate Services in Jersey, which is the Channel Island trustee in the Caravan I deal, “because there is some doubt over whether you can securitise debt and still comply with Shariah doctrine.

Having said that, it does open up a larger class of assets that can be securitised, such as the accounts receivables of mobile phone companies, or other utilities companies, or of airlines.”

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“Islamic issuance is now a force to be reckoned with,” says Richard Stewart, Counsel Banking and Finance at Bryan Cave, the specialist law firm in London.

According to estimates provided by the General Council for Islamic Banks and Financial Institutions (GCIBFI), pureplay Islamic banks and financial institutions today manage some $260bn of assets. A further $200bn to $300bn is managed by the Islamic windows and subsidiaries of international banks in the world’s major financial centres.

“I read everywhere that foreign investor interest in Islamic financing is growing daily. Up to now I haven’t seen it. But these securitisation deals could change all that.” says Robert Christensen.

So far Al Manar will not release much information about the deal and did not speak to us. “If we can understand the deal, it would be an exciting development,” says Christensen. “There is a substantial difference between conventional securitisation deals and Islamic compliant structures,” he explains. “In a conventional structure, you have different classes of debt which pay variable interest rates. In a Shariah compliant structure it’s not possible to create such tranches and you have to contend with a number of other Shariah compliance issues.” Islamic principles prohibit interest and quasiinterest-based lending. Islamic finance is based on contracts which do not have interest, and is usually based on sharing of risks and/or rewards.

The principle is based on a Koranic rule that Muslims can support or

invest in others' businesses on the basis of partnership, but not on the basis of interest. The foundation of any Islamic financial engineering is an understanding of the balance between fixed features of Shariah [such as certain prohibitions] and the fixed tenets of Koranic law and dynamic features, such as rules on Mu'amalat (dealings), “and the understanding that everything is permissible unless it is forbidden,” says Bryan Cave’s Richard Stewart.

Bankers often resort to using doctrines of necessity (Darurah) and common need (Al Hajjah Mushtaraka) as justification, and in some cases classical Islamic instruments have been adapted to modern needs: “for example Ijarah for operating leases and Mudarabah for investment management,” explains Stewart. In other cases, such as Sukuks, financing structures have been derived from western, conventional financing instruments.

In a securitisation deal, the underlying asset must be compliant with Islamic principles, the asset must be owned and used in a compliant manner and the securities issued by the SPVs and the SPVs themselves must be compliant as well. Volaw’s Christensen admits, that it does create problems: “there are greater costs in putting deals together in an Islamic context, but as the volume of deals increases the cost per transaction will decrease and value will rise,”he says.

Caravan I is significant for a number of reasons: it is the first Islamic compliant securitisation in which the assets are in the private sector and

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Regional Review MIDDLE EAST

which are physically located in the Gulf countries. Until now, Sukuk typically are backed by government agencies.

The structure also has several structuring and credit enhancement features and benefits from embedded early warning triggers, thereby mitigating performance risk. More importantly, the deal is structured with a dual jurisdiction, two-tier special purpose vehicle structure.

A newly-created Jersey special purpose vehicle [SPV], Caravan I Limited, issues asset-backed securities, which finance the purchase of assets by a Saudi Arabian SPV through the issue of Sukuk – Islamic investment certificates that comply with Shariah principals – to investors in the Gulf Cooperation Council [GCC] countries.

The Saudi SPV owns the vehicles, which are then leased to a number of companies in Saudi Arabia, the leased vehicles being serviced by Hanco. The Sukuk were approved by Yasaar Limited, the providers of Shariah compliance advisory services on behalf BSEC, who were the originators in the deal; while Sh. Nizam Yaquby of Bahrain acted on behalf of Shamil Bank in Bahrain, the underwriters of the deal.

“Hanco sold part of its fleet to the Saudi SPV,” explains Robert Christensen. “It’s a much cheaper source of financing for Hanco, allowing it to finance the purchase or more vehicles for its fleet.”

The Sukuk have a three year maturity and offers Islamic investors a variable rate of return, paid on a monthly basis, with a forecast return over their life of 6%. The Sukuk were privately placed with investors in the Gulf. “I’m confident that there is a large market in the region for this type of financing and that it opens up a new and cost effective way to finance companies. It also offers investors a new asset class, that was previously unavailable to them,” says Robert

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Christensen,“There’s huge wealth that would like to invest in the region.”

Two problems, says Christensen, hold back Islamic financing from being regarded as a viable investment instrument by non-Islamic investors.

There’s no secondary market in Islamic debt and “Islamic banks need to create liquidity,” he adds. Bryan Cave’s Stewart agrees: “People simply do not want to tie up money for too long.”

Volaw is now talking to another Islamic bank which is interested in a similar financing structure and which is considering listing on the Channel Islands exchange. “The Sukuk structure tends to be placed with private investors, there’s no reason for not listing the securities on exchanges.”

“We’re seeing the emergence of hybrid structures.”

The challenge for local and foreign financiers is to make Islamic products and services fiscally sound and competitive, and then to make them available to all who want them.

“Innovation is key to the industry’s future”, says Nemeh Sabbagh, managing director and chief executive officer, Arab National Bank [ANB] in Riyadh. He is adamant also that effective risk management is important and reassuring for foreign institutional investors wanting to be involved in the market. Currency conversion is important and foreign exchange [FX] risk management is integral to this process: “FX risk in Islamic financing is managed by denominating the Islamic transactions in the currency required by the customer. We then purchase and sell the underlying asset to the transaction

in that same currency, thereby eliminating any FX risk,”he adds.

Bryan Cave’s Stewart agrees: “We’re seeing the emergence of hybrid structures. We recently did a deal with mixed financing that was half Islamic and half western. It’s increasingly common.”

Islamic financing as a readily investible vehicle for institutional investors outside the Gulf still has some way to go. Many Islamic financiers cite the common goals of improved revenue performance, cost reduction, increased market competitiveness and the adoption of complementary skills, as critical to future growth. Others, such as ANB, highlight the importance of developing in-house capabilities, product diversity and a strategic geographic focus. “The current economic environment is very healthy with the high oil prices and low interest rates continuing to have positive benefits for all businesses within the bank. This is leading to continued growth in loans and deposits, as well as non-interest income, which is expected to continue over the next year,” says ANB’s Nemeh Sabbagh.

“Assessing longer-term prospects in such a heterogeneous industry is risky – definitions of Islamic finance are often fudged in a market where specialised development banks can sit alongside investment boutiques and co-operative institutions – all of which will be affected by a different set of market factors,” says Bryan Cave’s Stewart. However, as an Islamic industry its future growth prospects will largely be dictated by the sociopolitical developments in Muslim countries, he adds. What is certain is that Islamic finance is increasingly perceived as a highly complementary addition to conventional finance and a potentially viable set of investible instruments for non-Islamic institutional investors.

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EUROPE

FTSEurofirst celebrates first year The FTSEurofirst Index Series, a joint venture between FTSE Group and Euronext, was launched with much fanfare on 29 April 2003. One year on, the FTSEurofirst 80 and 100 indices have firmly established themselves.

Welcome competition RIOR TO THE launch of the FTSEurofirst indices there was little alternative to the Dow Jones Euro STOXX 50 Index. This lack of competition compared to the US or Japan was believed by many to have been holding back the market. Carl Beckley, director of research and development at FTSE thinks that, “Investment houses in Europe had been wary of the lack of choice and the issues attached to such a monopoly.”

A number of fund managers had complained that there were a number of broad indices [300 plus equities] or narrow indices [50 equities] but there was little available to asset managers comparable to a traditional sized European portfolio [around 100 equities]. According to Mark Makepeace, chief executive of FTSE, the desire for a broader-based benchmark was a key factor in the development of the indices.

“FTSEurofirst gives investors the chance to track the performance of a broad-based benchmark more closely by using a larger number of stocks

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There are a number of perceived benefits in the market of a broader index including a lower tracking error from benchmarks, increased exposure to under-represented sectors, lower volatility and a larger proportion of the European capitalisation.

Ultimately, however, the success of an index is likely to be measured by the number of investment products linked to their performance. The first tracker on the FTSEurofirst 80 Index was launched last September by Lyxor Asset Management which was quickly followed by a number of other asset management firms including Crédit Agricole and also Pensionskasse Post [the Swiss Postal Service pension fund] adopting the FTSEurofirst 80 as a benchmark. More firms look set to follow with a number of product launches planned.

According to Xavier Leroy, a director of FTSEurofirst at Euronext, “We now expect a number of announcements from asset managers in Spain, Belgium, France and the UK about the launch of new products to be made over the coming months.”

“The FTSEurofirst index series has shown itself to be a real contender in this busy and competitive market in its first year,” added Makepeace.“This is true not only in the derivative and ETF markets but also as an indicator of European market performance,”

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Derivatives underpin success Much of the success of the indices can be attributed to the launch in June last year – just two months after the indices – of the FTSEurofirst 80 and 100 index futures and option products.

Volumes and liquidity have increased since the launch, particularly for FTSEurofirst 80 Index futures contracts.

In February the FTSEurofirst 80 index traded 90,064 lots – up from just over 10,000 in June last year. Indices used for financial products need to include liquid components to enable arbitrage and hedging transactions in the underlying markets.

The improved liquidity is putting downward pressure on transaction costs, though this has already been kept deliberately low by having only one annual review. A smaller number of changes benefits indices users by minimising the turnover and rebalancing costs inherent in any index fund. These low costs and the transparent structure of the indices suggest that looking ahead FTSEurofirst will have plenty more anniversaries to celebrate. Makepeace is confident that, “FTSEurofirst will continue to provide a solid framework for FTSE Group's plans to further develop our business in this area.”

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COVER STORY

IT’S THE DELIVERY THAT COUNTS In a business in which mega-mergers have disrupted customer relations at least as often as they’ve created shareholder value, the mission of CEO-in-waiting James Dimon of the soon-to-bemerged JP Morgan Chase and Bank One could be a tall order. Indeed, both sides of this latest blockbuster deal are products of relatively recent disappointing mergers. Everyone expects a lot from Dimon and the enlarged bank. But will the elbowing management style of CEO-in-waiting, James Dimon, sit comfortably with JP Morgan Chase’s more genteel ethos? Bill Stoneman tells all.

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HEN JP MORGAN Chase & Co completes its pastimes – cutting costs and restructuring – may be harder $58bn acquisition of Bank One Corp in a few to effect.” In a business, therefore, in which mega-mergers months, the financial services conglomerate will have disrupted customer relations at least as often as have 164,100 people on the payroll. But favourable reviews for they’ve created shareholder value, Dimon’s mission appears the deal – and observers have generally praised it and mostly to be a tall order. Indeed, both sides of this particular deal say it will be good for investors – come down largely to faith are products of relatively recent disappointing mergers.

Chase Manhattan Corp’s acquisition of JP Morgan & Co in one man, James Dimon, Bank One’s chief since March 2000 in 2000 was greeted with favourable reviews when it was and CEO-in-waiting at the newly combined company.

“The guy is brilliant,” says Richard Bove, a bank stock announced. But earnings plummeted immediately on a analyst with Hoefer & Arnett, an investment bank long list including general weakness in capital markets, specialising in financial companies, offering the widely held losses on trading, loans to Enron Corp and WorldCom Inc and an over-valued portfolio of private equity investments. view among people who watch banks and their shares.

By the time the pending Dimon, according to Bank One deal was financial services lore, was announced, analysts said JP the nuts-and-bolts mechanic In the fragmented US market, post-merger Morgan sorely needed a who made one deal after Morgan Chase will have about 9% partner whose mix of another work for Sanford of all deposits. Its 2,295 retail offices business would smooth out Weill, in the course of their will give it the fourth largest branch its own volatile earnings. assembling Citigroup Inc. He network in the US The current Bank One, was fired in 1998 after a series meantime, was created in of run-ins with Weill. But he 1998 when predecessor Banc can easily claim credit for helping to build what would later become the most One Corp acquired First Chicago NBD Corp. Its earnings profitable company in the US. When he took over Bank also tanked quickly, more due to troubles at First USA, a big One, Dimon walked into a company with serious problems, credit card company that it bought a year earlier. That led to led by bad loans and incomplete melding of multiple the ouster of John McCoy, the executive who engineered computer systems in use after a long string of acquisitions. both deals, and the subsequent hiring of James Dimon.

Bank One has rebounded, but is concentrated in By all accounts, he has skillfully turned Bank One around.

“Jamie Dimon has done a stupendous job of cutting businesses that don’t have great growth prospects in the operational risk,” says David Hendler, senior analyst with next year or two, say analysts.

The combination of JP Morgan Chase, a commercial and CreditSights, an independent research firm, “cutting costs investment banking giant based in New York, and Chicagodramatically and successfully integrating major systems.”

He’ll have to do it all over again for the JP Morgan based Bank One, which has larger retail banking and credit Chase/Bank One combination to live up to its billing and card businesses, will trail only Citigroup among US banking before he even gets the top job in the company. At companies in assets, and even that by only a modest minimum, Dimon must cut operating costs at the same time margin. It will have about $1.1trn in assets, compared with that he leads an error-free integration of staffs and systems. Citigroup’s $1.2trn assets. Market capitalisation, however, is The long-term test will be trying to boost revenue, which another story. Morgan Chase and Bank One had a doesn’t come easily in a super-competitive business. combined market cap of $130bn at the time of the deal’s Executives and analysts say the deal offers ample revenue announcement, about half of Citigroup’s total. opportunities, but the official announcement only quantified The deal continues a game of leapfrog among banks goals on the expense side of the equation. Moreover, Dimon jockeying for position among the largest in the US. Morgan isn’t scheduled to become the combined company’s chief Chase, which had $793bn in assets at the end of last year, will executive officer until some time in 2006. He will work until be nosed out for second place by Bank of America Corp briefly then for JP Morgan Chase’s CEO, William Harrison Jr, about when it completes its acquisition of FleetBoston Financial whom it is much harder to find glowing praise. In addition, Corp in April. Bank One had $290bn in assets at the end of Harrison is expected to continue on as the company’s last year, making it the sixth largest US banking company. chairman after he relinquishes the chief executive’s job.

In the fragmented US market, post-merger Morgan Most observers expect Harrison to give Dimon all the Chase will have about 9% of all deposits. Its 2,295 retail latitude he needs. One industry specialist, however, Nancy offices will give it the fourth largest branch network in the Bush, an independent bank stock analyst, cautions against US. The company will have the second largest credit card anyone being too certain about that. business, with $125bn in outstanding balances on 95m “We would be concerned that Mr Dimon’s sharp elbows,” cards. Morgan Chase alone ranks fourth in global debt, Bush wrote to her clients shortly after the deal was equity and equity-related underwriting in the first three announced,“much in evidence at Bank One – will not set months of this year, following Citigroup, Morgan Stanley [sic] well with the more genteel ways of the legacy Chase and Merrill Lynch, according to Thomson Financial, with crowd [including the directors] and that his two favourite $102bn raised for clients. And though its business is far

W

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more concentrated in the US than Citigroup, Morgan Chase has offices in more than 50 countries, the legacy of both its JP Morgan and Chase Manhattan roots. In addition, the combined company will have a big asset management business and a modest-sized insurance business.

The agreement between Morgan Chase and Bank One includes an exchange of 1.32 shares of Morgan Chase for each Bank One share. Based on prices of both companies just before the deal was announced, Morgan Chase is paying a 14% premium to Bank One shareholders. In addition, the agreement creates a 16-member board, including Harrison, Dimon, and seven others from each side. It nearly guarantees that Dimon, 48, will become CEO, stipulating that the job is his unless three-quarters of the board votes against his ascension. Dimon will serve as president and chief operating officer and will head the retail business until Harrison, 60, steps aside.

The deal, which is expected to be completed in June or July, can benefit shareholders in a number of ways, analysts say.

Even without boosting earnings, Bank One’s retail business should smooth out the extreme peaks and valleys in the current Morgan Chase’s earnings, says Steve Wharton, an analyst for Loomis Sayles & Co, a mutual fund company.

Investors will reward the company just for that, he adds, with a higher price-to-earnings multiple. Morgan Chase traded for 13 times last year’s earnings in late March, compared with price/earnings ratios [P/Es] of 15 for Citigroup and 16 for Wells Fargo & Co Inc, the fourth largest US bank.

Executives promise, however, that they’ll boost earnings just from cutting costs. They project saving $2.2bn, or 7% of combined non-interest expenses, over three years, excluding $3bn in merger-related expenses. Projected savings include $700m in wholesale businesses, $800m in card and retail businesses and $700m in corporate functions. Executives say they’ll also drive earnings with increased revenue, though they have shied away from attaching any numbers to that assertion.

“That still remains Jamie Dimon’s challenge,” says CreditSight’s David Hendler, noting that Dimon achieved far more with cutting than growth at Bank One. Thomas Kelly, a Bank One spokesman, who says Dimon would not comment for this article, provided examples of

Bank One’s CEO, James Dimon happily shakes the hand of JP Morgan Chase’s CEO, William Harrison Jr.

revenue-generating potential produced by putting the two companies together. Bank One, which does not have a significant mortgage business, will gain access to Morgan Chase’s mortgage capabilities and as a result should capture more business from its retail customers, explains Kelly.

Similarly, he says Bank One’s corporate customers will be interested in the equity underwriting that Morgan Chase offers. In the opposite direction, Bank One has worked hard in the last three years to reinvigorate a sluggish branchbased business and ought to be able to teach Morgan Chase what it has learned in the process, he said.

After losing 200,000 checking accounts in 2000 and another 100,000 in 2001, the bank gained 17,000 in 2002 and then 434,000 in 2003. Kelly explains it as the result of: “getting our act together in retail banking”.

Working in the deal’s favour is a relatively low premium that Morgan Chase is paying over Bank One’s preannouncement price. By comparison, Bank of America paid 45% more than FleetBoston’s pre-announcement price in sealing that deal.

Bank One All figures in US dollars Earnings per share Net income [millions] Book value [at Dec. 31] Market price [at Dec. 31]

1998 2.61 3,108 17.31 51.06

1999 2.95 3,479 17.34 32.00

2000 -0.45 -511 15.90 36.63

2001 2.28 2,638 17.33 39.05

2002 2.80 3,295 19.28 36.55

2003 3.11 3,535 20.92 45.59

2.27 4,745 17.39 47.33

3.69 7,501 18.07 51.79

2.86 5,727 21.17 45.44

0.80 1,694 20.32 36.35

0.80 1,663 20.66 24.00

3.24 6,719 22.10 36.73

JP Morgan Chase Earnings per share Net income [millions] Book value [at Dec. 31] Market price [at Dec. 31]

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Moreover, the deal comes at a time when share prices of both companies should be headed upward for reasons having nothing to do with the transaction, says Richard Bove, the Hoefer & Arnett analyst. Corporate capital spending in the US is recovering, he says, providing a foundation for stronger commercial and industrial lending and project financing for both companies. Higher stock prices have already re-ignited mergers and acquisition activity and equity underwriting – major sources of revenue at Morgan Chase. As a result, Bove is recommending banks with strong commercial businesses and urging clients to sell banks that depend mostly on consumer business.

Not everyone is convinced, of course, that the outlook for Morgan Chase is strictly positive. Analyst Nancy Bush, for example, wrote to clients that although the deal looks cheap when measured by premium, the price isn’t as attractive when measured in other ways. In fact, in priceto-earnings or price-to-book value terms, Morgan Chase is paying much closer to the same amount that Bank of America paid for Fleet. In addition, Bush wrote that “matters of style and practice can easily escalate into major ruptures” when boards are composed of an equal number of directors from both sides of a transaction.

As big as it is in dollar terms, the transaction shouldn’t drive competitors to revamp their business or M&A strategies, analysts say. Industry consolidation pressure will continue, especially on banks with slow revenue growth.

But few suggest that combining Morgan Chase and Bank One creates a much tougher foe in individual lines of business – at least right away.

One competitor, who has been moving aggressively onto Morgan Chase’s retail turf, in and around New York City, says he is unimpressed.

“Almost every major bank merger in America has failed to create shareholder value,” says Vernon Hill II, chairman and president of Commerce Bancorp Inc. in New Jersey.

That’s because they’re almost always premised on cutting costs, which ends up causing disruption among customers and staff alike, he adds.

Even the deal’s supporters don’t voice all that much excitement about the specific projected cost cuts or the identified potential for revenue gain. The difference between this and other big financial services mergers and acquisitions, they say, is Dimon, who at various times gets credit for surrounding himself with some of the sharpest managers in the business, cutting strategic deals and keeping his troops focused on basic execution. If anyone can fulfill cost cutting projections without messing up customer relationships, it’s Dimon they say. And that should lead to revenue growth, though perhaps not immediately.

Dimon brings a bit of personal drama to the story, too, which just maybe will provide an extra measure of motivation. The business combination will bring Dimon back to New York, where he grew up and where he made his mark at Sandy Weill’s side, perhaps with something to prove to his old boss and mentor.

The Jamie Dimon story begins in 1982 when he visited Weill, for whom his father had worked as a stockbroker, seeking career advice. Weill, then the Number Two executive with American Express Co, took Dimon on as his assistant.

When Weill suddenly quit three years later, Dimon left with him and the two looked for something new to do.

A year later, Weill bought an ailing finance company in Baltimore, Commercial Credit Co, which served as the foundation for an incredible string of ever-larger acquisitions. First it was Primerica Financial Services Group, which included the Smith Barney brokerage firm. Then it was Shearson Lehman Brothers. Then Salomon Brothers, Travelers Insurance and finally Citicorp in 1998. Along the way, Dimon held such positions as president and COO of Travelers, chairman and co-CEO of Salomon Smith Barney.

He was president of Citigroup, working beneath duelling co-chairmen Weill and John Reed when he was fired.

Dimon moved quickly at Bank One, replacing nearly all of the company’s top executives in his first year, in many cases with former Citigroup colleagues. He shrunk the board from 22 directors to 13 and he slashed away at major and minor expenses, such as by closing down an experimental Internet banking unit that didn’t use the Bank One name.

He combined multiple subsidiary banks into one legal entity, reducing regulatory costs, integrated computer systems. He stemmed account haemorrhaging in the credit card business and strengthened the company’s balance sheet by cutting its dividend. His biggest mistake, by many accounts, was chasing away mid-sized business borrowers that didn’t bring enough other business to the table.

The net result was turning a $511m loss in 2000 into a $3.535bn gain by last year.

No wonder, then, that Dimon has a fervent following. In a sense, however, his next challenge begins without final accounting for his last one. Strong as last year’s earnings were at Bank One, they were up only 1.6% from 1999’s level, the year before he arrived. Whether all the new checking accounts opened last year presage sustained revenue growth, clearly needed to take earnings to the next step, will be hard to know when Bank One’s financial results are folded into Morgan Chase’s.

JP Morgan Chase v Bank One v All US Banks performance 1999-2004 120

100

80

Rebased Values

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60

40

20

0 Mar99

Mar00

Mar01

24

Mar02

Mar03

Mar04

Date FTSE US Banks Index (Large/Mid Cap)

Bank One

JP Morgan Chase

Source: FTSE

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should love

CHINA

Why investors

ETFs Open-end Exchange Traded Funds [ETFs] combine the advantages of both open and closed-end funds. They are easy to trade and regulate, with lower cost, high flexibility, liquidity and transparency. Zhu Shan and Luo Yinghao report from Beijing on the opportunities and problems facing ETFs in a reforming China.

BURGEONING REFORM programme and consistent growth figures [in excess of 8% per year] underscore the solid investment opportunity that is now China. In this climate – and in spite of some short term niggles over initial public offerings – its securities markets will continue to develop and deepen. As of the end of March this year, there are over 1,300 companies listed on China’s A share market with a total market capitalisation of RMB5,077bn – the equivalent of some $450bn, which is equal to $150bn after free float-adjustment. Now, say government officials, the key message of 2004 is that there is an increasing focus on quality – whereas in past years, the emphasis was purely on growth. This will have significant impact on the performance of ETFs, as China looks for more balanced development.

An expanding group of institutional investors in China will increasingly utilise ETFs, because they provide

A

flexibility, high liquidity and low costs. During the fiveyear period beginning in 1998, securities investment funds in China have grown exponentially. They now dominate stock trading. At present, there are a total of 82 individual funds in China available to the public, representing 10% of the freely-traded market capitalisation. Among them, 54 are closed-end funds and 28 are open-end funds. As the fund management sector in China continues to grow, the force of competition will drive fund managers to launch more innovative, low-cost products, such as ETFs. The move is important. While China and its stock markets have enjoyed remarkable growth over the last decade, foreign institutional investors’involvement in the market has been severely limited. Of the market’s total combined capitalisation [excluding Hong Kong] some two thirds is illiquid. As well, some 72% of the market’s capitalisation is taken up by A shares that can only be traded by Chinese residents. [see Box: The alphabet of Chinese shares].

Table 1: Number of Fund Management Companies, Number of Funds Under Management and Assets Under Management

No. of Fund Management Companies No.of Funds Under Management closed-end open-end Assets Under Mgmt. [RMB billions] closed-end open-end

1998 5 5 / 10 /

1999 10 23 / 51 /

2000 14 41 / 62 /

2001 14 49 3 69.9 118

2002 17 54 17 81.7 490

2003 29 54 28 81.7 556

Sources: China Securities Journal and other published statistics

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In the insurance industry, premiums are increasing dramatically. Funds available for institutional investment from premiums in 2002 amounted to RMB350bn [$42bn], compared with only one sixth of that in 1995 – the latest figures available. Of the RMB579bn [$69bn] in total Chinese insurance industry investment capital, some 70.6% was invested in bank savings and the government bond market with a rate of return of only 3.14%, according to Securities Time. The National Social Security Fund of RMB124bn [$14.9bn] meanwhile generates an annual return of just 2.75%. A significant percentage of these funds, seeking to generate higher returns, will be directed invariable to equity investment and thereby increasing demand.

ETFs also help meet some of the professional investment demands of Qualified Foreign Institutional Investors [QFIIs] in China. At the end of 2002, the government announced new procedures for the establishment of China Securities Regulatory Commission [CSRC], an administration to regulate QFIIs, which were allowed to invest in domestic China A shares for the first time. By August of last year, five foreign institutions had been approved by the agency – the Chinese equivalent of the Securities Exchange Commission in the US – with a total approved investment quota of $725m. QFII investment amounted to $1.7bn at the end of 2003, and some observers think that these figures will double this year.

For institutional investors, investment in ETFs is a common strategy for entry into new geographic markets, rather than the selection of individual stocks with the associated assumption of individual corporate risk.

The underperformance in recent years by active managers in the Chinese equity markets makes the advantage of indexed investment in that market even more striking. The Shanghai Stock Exchange [SSE] and China Galaxy Securities Co, the largest Chinese brokerage house, separately analysed the general performance of the institutional fund community in

China, using data from 1999 through the first half of 2001.

Both research studies reached the same conclusion: the growth of net assets within the securities fund sector had generally under-performed the Chinese market indices.

Moreover, the entire fund management industry did not show any real skill at selecting stocks or making “timing-related investments”.

Market indices, such as the FTSE/Xinhua Index Series, have been developed in China using global standards of compilation and are important for the further development of ETFs in that market. Other major index series in China include the Shanghai Stock Exchange Index Series and the Shenzhen Stock Exchange [SZSE] Index Series. The stock exchange indices cover only shares traded on each respective exchange, while the FTSE/Xinhua Index Series covers the entire Chinese market.

Though the Shanghai [Stock Exchange] Composite Index and Shenzhen [Stock Exchange] Composite Index have great market influence, they are difficult to track due to lack of transparency and frequent changes in their constituents. As a result, they are not an effective benchmark for ETFs. The FTSE/Xinhua Index Series includes a China A Share Series, a China B Share Series, the China 25 Index [including the largest issuers by market capitalisation] and a China Government Bond Index.

Boshi Fund Management Company, one of the foremost fund management companies in China, has adopted the FTSE/Xinhua A 200 Composite Index – the Chinese counterpart to the S&P 500 in the US – as the tracking benchmark for the Boshi FTSE/Xinhua Fund. Barclays Global Investors [BGI] is going to add iShares FTSE/Xinhua Hong Kong China 25 Index Fund to its international ETF offering and was the first ETF available to US investors that tracks the Chinese market. BGI still awaits formal SEC approval for its iShares fund.

With the launch of more index-tracking funds and a recent blitz of media coverage, Chinese investors have begun to accept indexation and to understand the objectives and trading mechanism of ETFs.

Table 2: Approved QFIIs [by January 2004] QFIIs UBS Limited Nomura Securities Morgan Stanley Citigroup Global Markets Ltd Goldman Sachs Deutsche Bank HSBC Hong Kong ING Bank NV JP Morgan Chase Bank CSFB Hong Kong

Investment Quota $ millions 600 50 300 200 50 200 100 100 50 50

Custodian Banks Shanghai Branch, Citibank Shanghai Branch, Citibank Shanghai Branch, HSBC Shanghai Branch, Standard Chartered Shanghai Branch, HSBC Shanghai Branch, Citibank China Construction Bank Shanghai Branch, Standard Chartered Shanghai Branch, HSBC ICBC

Source: Official statistics from China Securities Journal and FTSE Xinhua

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There are some obstacles to the development of ETFs in China at present. The major obstacle is a policy limitation set by relevant laws and regulations.

Currently, there are two types of investment funds, closed-end funds and open-end funds, which are regulated by different laws and regulations such as the Interim Measures for the Administration of Securities Investment Funds, Trial Provision of Open-end Fund, Securities Law of the People's Republic of China, the Listing Rules of the Shanghai Stock Exchange [SSE] and the Shenzhen Stock Exchange [SZSE] and the Depository and Clearing Rules of the China Securities Depository and Clearing. ETFs are special forms of open-end funds traded on the Exchanges. The current laws and regulations do not take ETFs into account. Therefore, the development of China’s ETFs will face some juridical issues, including: • The trading mechanisms are different for common open-end funds and ETFs which use a basket of shares in exchange for the fund unit. Therefore, relevant cash

trade regulations on common open-end funds are not suitable to the development of ETFs. • The special trading mode of ETFs in the primary market requires the non-trading transfer of a portfolio of securities which should benefit from tax exempt treatment. However, there is a strict restriction on nontrading transfers under the current Depository and Clearing Rules that definitely would impede the development of ETFs in China.

• Since ETFs employ indexed investment, current regulations pertaining to limitations on investment weightings [for example, stipulating that investment in government bonds should be no less than 20% of the value of a fund or that investments in any single stock should not exceed 10% of its free-floated market capitalisation] are not applicable and will therefore have a negative effect on the development of ETFs. • The ability to sell shares short is a key advantage of ETFs that distinguishes them from other open-end funds. However, short-selling is prohibited by the current laws and regulations in China.

• Since a large number of stocks are involved in the creation-redemption process in primary market trading, T+0 settlement has been widely introduced in foreign markets to provide investors with sufficient arbitrage opportunities. However, under current regulations in the Chinese securities markets, only T+1 trading is permitted.

Although there are some obstacles to the development of ETFs in China, FTSE Xinhua Index, and the Shenzhen and Shanghai Stock Exchanges and fund management companies are making great efforts to develop Chinese ETFs in the current legal environment.

The SSE has done in-depth feasibility research on ETFs and has designed a project to develop ETFs in China. The resulting report suggests that some legal and regulatory

The Relative Performance of the FTSE/Xinhua China A and B All-Share Indices

The Relative Performance of China, the Emerging Markets and All World Indices

Number of Funds and Asset Under Management 90

1600

80

1400

70

1200

60

1000

50

800

40

600

ss

30 20

400

10

200 0

0 1998

2000

2002

No. of Funds Under Management Asset Under Management [100 Million Units]

Source: FTSE

Limits on ETFs

200

140

190 180

130

Rebased values

Rebased Values

170 120

110

160 150 140 130 120

100

110 100

90

90 80

80 Mar03

Apr03

May03

Jun03

Jul03

Aug03

Sep03

Oct03

Nov03

Dec03

Jan04

Feb04

Mar04

Mar03

Apr03

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 4

Jun03

Jul03

Aug03

Sep03

Oct03

Nov03

Dec03

Jan04

Feb04

Mar04

FTSE/Xinhua China A 200 Index

FTSE/Xinhua China B All-Share Index

Source: FTSE

May03

Date

Date

FTSE/Xinhua A All-Share Index

FTSE All-World Index

Source: FTSE

FTSE Emerging Index [Large/Mid Cap]

27

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CHINA

The definitive measure of Chinese Markets

7/4/04

INDEPENDENT

GM EDITORIAL.QXD

For further information, visit Bloomberg, type FTXI <GO>

restrictions [such as the prohibition against short selling] currently standing in the way of the introduction of ETFs into China can be remedied by the implementation of advanced technical systems through which the technique of timely arbitrage can be realised.

SZSE has also developed the Listed Open-end Fund [LOF] as a substitute product for ETFs under current Chinese laws and regulations. Boshi Fund Management and Ron Tong Fund Management Co Ltd co-operated with the ZSE to develop LOF products. In an LOF, the use of cash is substituted [in place of a basket of securities] in the creation and redemption process in the primary market, thus solving the problem of a non-trading transfer, presently prohibited in China. This provides flexibility for investment, especially for solving the mandatory treasury bond investment provision. In addition, the depository and clearing system for open-end funds developed by the Shenzhen branch of the China Securities Depository and Clearing, has built an infrastructure for the creation-redemption and arbitrage trading processes of LOF.

EXCHANGE TRADED FUNDS – AN EXPLANATION

E

TFS ARE OPEN-ENDED mutual funds that are listed and traded on a stock exchange. While ETF shares will normally be bought and sold on the exchange, certain designated broker dealers can also deal directly with the fund for creation and redemption. Creation and redemption of shares are normally made in large, pre-defined blocks of shares. The open-ended feature ensures that the market price of the shares on the exchange tracks the fund's net asset value per share fairly closely. At the same time, by restricting this activity to a small number of professional market participants, the fund enjoys significant cost savings in serving shareholders.

Why use ETFs? Fees for ETFs tend to be lower than the fees for comparable, traditional mutual funds, simply because operational costs are lower, as ETFs use exchange facilities to clear and distribute shares. Otherwise, ETFs offer many of the same advantages that closed end funds offer. Shares can be traded at any time that the exchange is open, instead of once per day [as is the case with regular mutual funds]. Investors pay only their usual brokerage commissions to buy and sell; there are no initial sales charges or redemption fees. Investors can also place limit and stop loss orders, buy on margin, or sell short to hedge a portfolio. In some cases options can be traded on ETF shares, just as they are for stocks. An ETF does not need to hold cash in anticipation of redemptions. This saves the fund trading costs and ensures that the fund is fully invested at all times.

Closed end funds have also tended to trade at large premiums and discounts to net asset value, due to fluctuations in market supply and demand. ETFs don’t have this problem because they accept subscriptions and redemptions for large blocks of shares on any trading day. This means that the market price will track the fair market value of the shares closely.

www.ftsexinhua.com

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THE ALPHABET OF CHINESE SHARES

REPRESENTATIVE

HINA’S STOCK MARKET remains strongly influenced by state policies. Further, its development is still constrained by being divided and fragmented. This helps prevent foreign companies and institutions taking control over Chinese companies and protects, as far as possible, Chinese stock markets from the vagaries of world market fluctuations. A, B and H shares are all considered to be emerging market companies, whereas red chips are technically Hong Kong companies. Therefore they are considered developed market companies. Technically then there is no difference between Hutchinson Whampoa and a China Mobile.

A Shares are securities of Chinese incorporated companies that trade on either the Shanghai or Shenzhen exchanges, are quoted in Chinese remnimbi and can only be traded by Chinese residents and a handful of investors under the QFII scheme [see below].

B Shares are securities of Chinese incorporated companies that again trade on either the Shanghai exchange, where they are quoted in US dollars, or the Shenzhen exchange, where they are quoted in Hong Kong [HK] dollars. They can be traded by foreigners and Chinese residents who have appropriate foreign currency accounts.

H Shares are those nominated by the government for listing and trading on the Hong Kong Stock Exchange and are quoted in HK dollars and there are no restrictions on the foreign companies that trade them. However, domestic Chinese investors cannot trade them.

Red Chip Shares There are two definitions of Red Chip shares.

The Hang Seng Index [HSI] defines red chips as companies with 30% government ownership and where 20% to 30% of the company’s revenue comes from mainland China. FTSE meanwhile defines red chips as securities of Hong Kong incorporated companies that trade on the Hong Kong stock exchange. They are quoted in HK dollars. Red Chips are companies that are substantially owned directly or indirectly by the Chinese government and have the majority of their business interests in mainland China.

An existing index constituent classified as Red Chip will however lose its status if its ownership by the mainland Chinese government – or Hong Kong companies that are controlled by the mainland government – has fallen below 25%.

A company not classified as Red Chip for the purposes of the FTSE/Xinhua 25 Index inclusion must have over 35% of its share capital owned by the mainland government, or Hong Kong companies which are controlled by the mainland government.

QFIIs are Qualified Foreign Institutional Investors.

NFIIs are a non-floated shares investment initiative. In the third quarter of 2003 came the news that QFIIs could now invest in NFIIs – basically investors can buy non-listed shares in Chinese companies. Non-floated shares tend to pay higher dividends, report local newspapers. For example, China Money Weekly research on 33 Shanghai-listed and 34 Shenzhen-listed companies, shows non-floated shares received 5.78% and 6.35% higher dividends than on the respective exchanges.

Domestic Bonds: The local Chinese bond market remains closed to foreign investors and is valued at some 34% of GDP – third in size only to South Korea and Japan].

The definitive measure of Chinese Markets

C

For further information, visit Bloomberg, type FTXI <GO>

www.ftsexinhua.com

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PROFILE: BGI Four years ago, Lee Kranefuss presided over BGI’s launch of iShares – a series of exchange-traded funds that combined index-fund style diversification with the liquidity of stock trading. With the Dow bouncing off the 12,000 mark, BGI’s roll out seemed particularly well timed. Then the market tanked, sending investors streaming for the exits and fund managers scrambling to contain the damage. Through it all, however, Kranefuss remained resolute. David Simons explains why.

ARCLAYS GLOBAL INVESTORS [BGI] came out with iShares just as the market was peaking recalls Lee Kranefuss, managing director of its Intermediary and Exchange Traded Funds division, from his office in San Francisco. “Naturally there was the assumption that because the froth was over that would hurt us,” says Kranefuss.“In fact, what we’ve seen is that a good portion of the market became very interested in what we were doing as a result of the pullback. Suddenly, diversification, low cost and tax efficiency mean a whole lot more when the big returns aren’t there. People have returned to a more basic approach to asset allocation, and this group of funds really fit that profile.”

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Kranefuss’ poise under pressure is all the more impressive considering he wasn’t even involved in finance the last time the bear came to town. Graduating from Cornell with a degree in electrical engineering, Kranefuss landed a job at Boston-based Teradyne Inc., a supplier of automatic test equipment for the electronics and communications industries. But by the late 1980s, Kranefuss’ lifelong fascination with equities paved the way for a complete career makeover.

Earning his MBA at the University of Pennsylvania’s prestigious Wharton School, Kranefuss headed west, where he served as a management advisor to both retail and institutional clients as part of San Francisco’s Boston

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Consulting Group. Among Boston’s largest customers was Barclay Global Investors, an early proponent of indexbased investing. In 1997, Kranefuss left Boston for BGI, becoming the company’s director of strategy and corporate development. Today, Kranefuss, 41, oversees Barclay’s line of exchange traded funds [ETFs] in addition to the company’s traditional family of mutual funds.

Oddly enough, Kranefuss’ tech legacy continues to inform the day-to-day decision making at iShares.“One of the things I always tell people is that quantitative money management looks more like engineering than most engineering does nowadays,” says Kranefuss. “As an undergrad I studied signal processing, and whether it is index or active, a lot of what we do around here is based on the same technology – it’s looking for signals and noise and seeing which ones you can rely on. If you walk around our building, you’ll see blackboards full of calculus. It’s a very statistical approach – it’s how they make satellite TV work, and, particularly on the West Coast, it’s also how this kind of money management works.”

ETFs on the Move Like index mutual funds, iShares [the “i” is a catch-all for “industrial strength”, “investment”and“index,”according to Barclays] track combinations of stocks linked to a specific index. But because their share prices constantly fluctuate [as opposed to being re-calculated once a day at the closing bell], ETFs look and feel more like actual stocks.

With its 85 fund groups, Barclays, which began offering exchange-traded funds in 1996, remains the industry’s ETF leader; within the last few years major players like Vanguard and Fidelity have come aboard with their own line of ETF offerings.“Naturally, that helps us,”says Kranefuss.“For the longest time ETFs were considered a fringe investment idea.

Now people are really starting to give them a second look.”

And with good reason. On a cost basis alone, ETFs rank among the market’s best bang for the buck, averaging around 0.47%, or nearly half the average expense ratio of index equity mutual funds. ETFs also have minimal capitalgains exposure, making them a solid choice as a taxadvantaged investment option.

With a frugal expense ratio of 0.20%, BGI’s latest ETF offering, the iShares S&P 1500 Index Fund, tracks the S&P Composite 1500 Index, an amalgam of the S&P 500, S&P MidCap 400 and S&P SmallCap 600 indices.“Particularly in the individual investor and advisor market, our aim is to sell a complete set of modular building blocks,”says Kranefuss.

“People have their tools that they use for portfolio construction, and they run them against things like the S&P and Russell indexes. We had people coming to us who use these indexes who wanted to have total market exposure.

The 1500 combines these indices, so you don’t have to go out and buy three different funds instead. It’s a good example of a fund offering that was really driven by client demand.”

Cultivating a new fund group isn’t for the faint of heart, even under optimal conditions. Despite the choppy market, Kranefuss is pleased with the performance of the

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Lee Kranefuss, managing director of BGI’s Intermediary and Exchange Traded Funds Division

iShares family thus far, which currently sits at around $69bn in assets [based on recent market moves]. “If anything we’re a little bit ahead of projections at this point,” says Kranefuss. “There are a whole bunch of forces that have actually helped make iShares more attractive than they might have been had the market continued to plough ahead. When you think the market is going up 50% every year, then a 2% management fee doesn’t mean that much – you just want something that’s going to triple in value in just a few months. That’s all changed. Suddenly, diversification, low cost and tax efficiency mean a whole lot more when the big returns aren’t there.”

As an example, Kranefuss cites the iShares Fixed Income Funds, a series of bond products that track indices created by Lehman Brothers and Goldman Sachs. “Four years ago, bonds were something your grandfather used, whereas real investors traded tech stocks,” says Kranefuss. “Nowadays a bond fund sounds like a downright innovative product. You put in money, you get payments, and you get the money back at the end. And you really diversify to avoid any potential trouble with defaults.”In a market moving in fits and starts, such tangible results have proven to be enormously popular among BGI investors.“There’s currently a combined $5.8bn in this group, making each of the six income funds bigger than any one of the iShares equity funds,” notes Kranefuss.

“They’re really working, and people like that.”

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Getting the Word Out

long enough to get both the tax and cost benefits,” says Despite the upward trend, exchange-traded funds in Kranefuss.“There’s the misperception that ETFs are a good general still have some serious catching up to do. Of the idea for so-called day traders. In reality, a lot of the largeroughly $7.5m in US mutual-fund assets, ETFs currently volume moves in ETFs are often the result of a small account for a mere 2% of the market total, or roughly number of institutions. Based on our market research, the majority of the individual $150bn and the lion’s share investors, both advised and of ETF activity remains self-directed, tend to be the centred in the US. Kranefuss buy-and-hold variety – estimates that about half of For an ETF manager like Kranefuss, they’ve done the cost-benefit all ETF business comes from luring more investors away from the analysis and understand that institutional investors, tried-and-true world of mutual funds is if you’re going into an ETF including large brokerage half the battle. and paying a brokerage houses, other money commission, you’re going to managers, hedge funds and come out ahead by staying the like. Though self-directed ownership remains low [at roughly 10%], the advised invested for the long term. So not only should the ‘ideal’ market has increased substantially since iShares debuted ETF owner be someone with substantial funds to invest in order to minimise the impact of the commissions, but four years ago.

“We’ve gone from around 70% institutional to about someone who is also willing to hold for a long enough half-and-half,”says Kranefuss, who credits BGI’s well-oiled period to maximise the tax and cost efficiencies.”

After years of scepticism, many experts now consider PR machine for the pickup in interest. “We’ve put forth a fairly substantial educational effort that includes ETF funds like iShares to be a truly plausible alternative to advertising, an extensive website, as well as 50 people on traditional mutual-fund investing in general, and index staff who are client-facing, most of whom have been out funds in particular.“The biggest problem with index funds there working with financial advisers and brokers. The is that they’re closed-end,” says Jack Dunn, investment influx of self-directed investors has increased as well. We’re analyst with A.G. Edwards.“The price they trade at doesn’t really starting to see the awareness factor pick up not just necessarily have to reflect the net asset value [NAV] of the with the institutions, which are always the first to come stocks in the group. Which means that when it comes time to get out, you could find yourself at a 10% to 15% discount aboard, but with every facet of the investing public.”

For an ETF manager like Kranefuss, luring more to the underlying assets. ETFs, on the other hand, seem to investors away from the tried-and-true world of mutual be a logical substitute for that kind of trading – because funds is half the battle.“The growth pattern has been great, they’re invested in open-ended companies, they track but we’re still in the early days of these funds,” observes much closer to the actual share value.”

Given the late-trading and market-timing headlines that Kranefuss.“Even if things continue at this pace, it’ll still be a while before we even see 10% of the market. So, yes, have rocked the mainstream fund industry of late, investors may be more willing to take a chance on second-tier inertia is a major obstacle at this stage.”

Overcoming the perception that ETFs are only for the vehicles such as ETFs. “This may be a particularly good sophisticated investor is yet another challenge, though in time for these funds, because of the trouble with the reality, ETFs really aren’t for everyone. As a fund group that traditional fund groups,”says Dunn. trades like a stock, ETFs, like stocks, also command brokerage fees. Which means that despite the low cost and Future Funds tax efficiency of an ETF, individuals who invest small With both equity and fixed-income markets well tapped, increments on a regular basis – and who don’t use a low- don’t be surprised to see a commodities-based iShares cost or flat-fee brokerage account – may wind up sacrificing product in the near future.“We do have a filing in for a gold a good portion of their return in the process. fund at the moment,” notes Kranefuss. “Because of the “Dollar-cost averaging is probably the most difficult area cyclical nature of commodities, we think a properly where ETFs are concerned,” admits Kranefuss. “If you’re arranged commodities portfolio is a sound idea for putting away $200 a month, you can’t really afford to be investors who want a decent return while minimising risk. giving away $20 per trade. I’ve seen them advertised as low It’s another area where we’ve had a lot of client interest – as $10 per trade, but even that is five percent of your followed by an active ETF, which is something the money, which is going to be very hard to overcome unless industry’s been trying to figure out for some time now. As you’re holding for a very long time. This is why the small the largest company in the ETF market globally, we’re investor who’s just starting out is going to be a lot better off always trying to grow the business, which means with a traditional mutual fund that can handle a monthly continually exploring new methods and products. We’ve $200 contribution.” gone from being part of a relatively obscure institution to So who, then, is the ideal ETF investment candidate? being able to bring a wide selection of funds to a very “Someone who is doing a large enough trade and holding diverse client base. It’s been a very rewarding time for us.”

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CURRENCY OVERLAYS

In the not-too-distant past, most pension funds wouldn’t give specialist currency managers so much as a foot in the door for a meeting – at least not when their stock and bond portfolios were still flying high. But the profile of currencies is playing differently in the funds across the US right now. Rosalyn Retkwa, in New York, explains why currency overlay specialists are the new kids on the block. So far only 15 firms have 90% of the market. It looks like an opportunity in the making.

“

Everyone, but everyone, wants

lpha

N THE SECOND half of the 1990s, many pension funds weren’t really concerned about a few hundred basis points here or there,” says Paul Duncombe, deputy managing director at State Street Global Advisors in London.

A study published by Mercer Investment Consulting of London in late 2000 estimated that on a worldwide basis, only 200 to 300 large pension plans were using currency overlay managers – “a reasonably large number,” but “only a small proportion of the total number,”the study said.

But the experience of 2003 was quite compelling for the Europeans says Duncombe. They saw their US equity holdings rally by more than 20%, but they also “gave back more than 10% because of the falling dollar,” he notes. As a result, “virtually every large pension fund is looking at

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currency now,” he says. “They can’t afford to ignore currency movements the way they used to.”

On the US side, up until the last 18 months or two years, the basic attitude had always been: “Why hedge our exposures when most of the time the dollar falls?”says Fred Bisset, the president and CEO of A.G. Bisset & Co in Rowayton, Connecticut, a currency management firm with more than $2bn in assets under management from 250 clients in 22 countries.

“What is happening now is that there’s a growing body of evidence that currency managers are reducing risk and also adding return by managing the exposures that are already owned by the pension funds,”Bisset says.

It’s that added return – called “alpha” – that has

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“It’s going to go up and down, and in some years it will everyone suddenly perked up and interested. “The buzz word is ‘alpha’; everybody wants alpha,” Bisset says, be negative, but it’s reasonable to expect 1% per annum on adding that his firm will be launching an alpha fund the value of your international assets from a standard currency overlay mandate,”says Muysken. sometime this spring.

Another study presented by Russell/Mellon CAPS of Likewise, Gary Klopfenstein, the president of GK Investment Management in Chicago, a currency London at the Currency Seminar hosted by Bank of America in Dublin in early February shows management firm with over $1.8bn that over the past five years, 87% of under management in currency currency overlay managers produced overlay programmes, says hedging positive excess returns, or returns that programmes “are almost being exceeded their benchmarks. In US bypassed”. Straight off, a lot of dollar accounts, the percentage pension funds are now “looking for producing positive excess returns was alpha.” He says that interest started even higher – 93%. to pick up noticeably about a year The new study is an update of an and a half ago, with an up tick in earlier one done by the Frank Russell the fourth quarter of 2003. “Having Company of Tacoma, Washington, one of these institutions come in one of the partners in the and ask us about the alpha business Russell/Mellon CAPS joint venture. has probably gone up by more than With the data from that earlier study 10% or 15%,”he says. included, the history spans the 16Duncombe agrees that “more and year time frame starting in 1988 and more, clients are wanting to talk ending in 2003. And, in that longer about using currency overlay as an Dori Levanoni, general partner at time frame, 68% of the currency alpha source rather than just as a First Quadrant LP in California overlay accounts surveyed positive traditional tool for defensive hedging.”State Street, which manages just over $45bn in its excess returns – on separate accounts, it was an average of overlay business globally, launched its first alpha fund about 0.88; and, on composites, 1.15, Russell/Mellon CAPS said.

And, yet, it’s still a largely untapped market, Bisset says. two years ago, he says. But it’s not that alpha has become the be-all and end-all; there’s still plenty of interest in basic “For every $5 in pension funds across the globe – in overlay programmes, he says. “Those funds that are not Australia/Asia, Europe, and the US - $1 has a currency risk interested in trying to generate extra alpha from an active attached to it, or 20%, which means that the [potential] currency programme are still interested in minimising the market is in excess of $2trn. But with all of the consultants who’ve done studies to date, the total amount they’ve been foreign currency risks in their portfolios,”he says.

And so it is that the relatively small group of currency able to collect data on is only $200bn to $225bn, which means managers who’ve struggled for years to gain the attention that just about 10% of the total estimated exposure is being addressed,”he says. That’s particularly true in the US, where of the pension plans have finally seen the door open.

The data for 2003 is still trickling into Mercer in London, the majority of pension funds still haven’t entered the but as of late March, the firm had received performance market. For example, Mark Thurston, a senior research results for 41 accounts – called track records – from more analyst with the Frank Russell Company in Tacoma, than 20 of the currency managers it monitors year-to-year. Washington, says that of the firm’s 60 pension fund clients – “That’s a large sample”of its total universe of 40 managers which are among the biggest pension funds in the US – only with 89 track records, says Bill Muysken, the firm’s global 12 are currently utilising currency strategies.

But the profile of currencies as an issue is rising in the head of research – enough to begin to draw some US. “No less a traditional investor than Warren Buffett conclusions about how the year went.

So far, the median for 2003 is a positive 0.8% within a made forays into the foreign exchange [forex] market in range of a positive 7.4% for the top 10% and a negative 2002,” notes Paul Eustac, the president of the Philadelphia 1.9% for the bottom 10%, adds Muysken. Compared to Alternative Asset Management Co in Philadelphia, which 2002, the median is down from 1.4%. But,“if you look at the runs a hedge fund that actively trades currencies.

In early March, Warren Buffett, the ‘Oracle of Omaha’ average performance of the active currency managers in recent years, more than half have been adding value, which released his latest annual letter, in which he said he had is better than what you normally see in most equity and increased his company’s ownership of five unnamed foreign currencies to $12bn in 2003, while blasting the Bush bond manager universes,”he says.

That 0.8% median is very much ahead of the median administration’s tax cuts and the ballooning US trade deficit.

“The driver in the forex market that’s dwarfing Mercer calculated in 2001 – 0.0%. As to how that striking number was accomplished, Muysken explains that in 2001 everything else right now is that US trade deficit,” Eustac “the majority of managers were early in forecasting the says. “The single biggest issue we’ll be grappling with in 2004 and probably in 2005 and 2006 and 2007 is the dollar to weaken, and it kept strengthening.”

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adjustment of the dollar to reflect the trade deficit, or the trade deficit will have to shrink,”he says, noting that “some academically inclined investors have said that it’s quite possible that the dollar needs to depreciate by 50%, which would be quite a drop.”And, there are risks that could bring about a massive devaluation of the dollar, he says. “For example, if China decided to let its currency float, it might appreciate 40% or 50% against the dollar, and there would be a serious dumping of dollar-denominated assets.”

But Eustac says that it’s also true – doomsday scenarios aside – that there’s been a “significant piece of diversification” into forex simply because money market yields in the US are so poor. Pension assets are moving into short-term instruments denominated in Australian or Canadian dollars or British pounds for the much more mundane reason that the yields are considerably higher, adds Eustac. “Relative to the equity and fixed income markets, the currency market as a tool for speculation has been underutilised by pension plans,”he says.

One of the big obstacles to further involvement by US pensions is that many of them have charters that prohibit currency speculation or “any derivative activities,” says Rick Sears, managing director at the Chicago Mercantile Exchange, which has roughly 97% of the volume in exchange-listed currency futures contracts.“It’s not that 80% [of US pensions] have chosen not to get involved,” he says, adding that with pensions, though there’s a perceptible “shift in that space,” change always comes slowly. Duncombe agrees that “in a relatively young business,” many pension funds are still bound by such restrictions, which they’re working to change. But the larger funds usually aren’t as hemmed in, and “it’s the large pension funds that tend to be the vanguard of these sorts of things,”he says.

Pension managers are also getting nudged along by“their financial directors and corporate treasurers,”Muysken says.

Given the accounting changes that will require them to report pension plan surpluses or deficits on their balance sheets, they’re “taking more of an interest in the company’s pension plan these days, and those people are more familiar with the concept of hedging out currency risks that you don’t really need to take,”Muysken says.

Dori Levanoni, a general partner in First Quadrant LP of Pasadena, California, a currency management firm with roughly $3bn in assets under management, has noticed another recent trend with the large pension funds that have been involved in currency programmes long enough to have gained some experience with them.

“They’re slowly increasing risk levels,” he says. A classic currency overlay programme is usually managed with a tracking error of 1% to 3% as a measure of risk, and that “risk level has started creeping up,” he says. It’s “not a pell mell run into hedge fund risk levels, which would be at 10% to 12%,” he says, “what we see simply is an increase from 1% to 3% to something more like 3% to 6%.”

But most pension funds have yet to get started. And, that gives the currency managers who’ve struggled along in the shadows for years the hope that their day has finally come.

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“There’s the appearance of a very large marketplace for skilled currency managers,” Bisset says, hopefully. And, there aren’t all that many of them, Duncombe notes:“There are maybe 15 firms who probably have 90% of the business,”he says.

WHY USE A CURRENCY OVERLAY PROGRAM

I

nvestment institutions either make discretionary decisions about currency exposure, or they formalise it: in other words they use an overlay strategy. Currency overlays separate exposure to exchange rates from exposure to assets held in corresponding currencies.

While currencies have a close-to-zero expected return over the long-term, they are extremely volatile in the short-term. With proper timing - and the right instruments - a currency overlay manager can add significant value to an international portfolio. Either the manager controls exchange rate risk effectively, or he successfully forecasts the direction of exchange rate movements, according to Dolefin, the Swiss investment advisory service.

Controlling risk reduces the volatility of international investments. The return enhancement [alpha] of the currency overlay manager is easy to calculate and does not require physical asset allocation since foreign exchange forward contracts are commonly used. The fund manager, in the meantime, no longer has to bother with currency forecasting but can focus on stock or bond picking.

Even with a portfolio consisting of, for example, neglected stocks or bonds that offer high incremental returns due to a lack of liquidity, the currency manager can do/undo his overlays in the liquid 24 hour foreign exchange market. Active currency management is now more frequently considered by European pension funds, who are taking advantage of the growth in the currency derivatives markets to alter their exchange rate exposure. A further reason for the growing importance of currency management is the increase in cross-border assets as a consequence of the European single market. Discretionary hedging by managers is more widely used than currency overlay. Currency manager First Quadrant, for example, only has a small part of its $2bn of currencies under management in overlay strategies, according to Mysis Asset Management. In addition to pursuing hedging strategies, some institutions look at currency overlay in order to add return to their portfolio. Pension funds find themselves looking at losses from their equity investments and fixed-income returns that are not sufficient to cover liabilities. Some of them also use currency management as an alternative source of returns.

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The recognition of the Cayman Islands Stock Exchange [CSX] by the UK’s tax authorities is a small move in the general scheme of things.

However, increasing recognition by OECD countries of offshore stock exchanges has changed the way that investors look at them.

Until now, offshore exchanges have specialised, in order to distinguish themselves from each other. But most are showing signs of wanting to expand their remit? Francesca Carnevale reports on the impact of the UK’s decision.

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T THE BEGINNING of March, the Board of the UK Inland Revenue office designated the Cayman Islands Stock Exchange [CSX] as a ‘recognised stock exchange’ under section 841 of the UK’s Income and Corporation Tax Act of 1988 [ICTA]. Firms listed on the CSX will be now able to take advantage of the UK Inland Revenue’s “quoted Eurobond exemption”. As a result, interest paid on securities listed on the CSX can now be paid without deduction of UK tax. Similarly, securities listed on the CSX are now regarded as ‘qualifying investments’, allowing them to be held directly in Personal Equity Plans [PEPs] and Individual Savings Accounts [ISAs].

The move is also the latest in a line of ‘recognitions’ by regulatory institutions in OECD countries, such as the US’s Securities and Exchange Commission [SEC] awarded to offshore exchanges. The UK’s Financial Services Authority [FSA] already designated the Channel Islands Stock Exchange [CISX] as a Designated Investment Exchange [DIE], as of February this year. According to Harry Taylor CBE, chairman of the CISX the FSA recognition is: “one which further enhances the Exchange’s competitive position. Coming soon after the US SEC designation and UK Inland Revenue recognition announced last year, this designation confirms the CISX’s international standing.”

Recognitions are important to the exchanges. Says Tamara Menteshvili, chief executive of the CISX says its recent designation: “will raise our profile internationally” and “signifies our commitment to the highest of regulatory standards and business practice.”

The search for recognition appears to be leading to something of a split between offshore regimes that have recognitions and those that don’t: Bermuda has, for example, while Panama is still waiting. Nonetheless, while an informal ‘tiering’ of exchanges is taking place, there are exchanges – namely the Swiss and Luxembourg exchanges – that refuse to be considered in the same bracket as many of the British territories and consider themselves in a league of their own.

While politics between offshore exchanges may be fun to record, recognitions are hard fought. As exchanges increasingly compete with each other, recognitions are important armour in the efforts of many offshore exchanges to move past their specialisations. As well, recognitions are promising to change the face of doing business in offshore markets. The much-trumpeted acquisition of Bank of

Bermuda by HSBC in February this year illustrates increased confidence of global financial institutions in offshore markets, such as Bermuda. Although indigenous banks and funds do not always list their funds and equities on the CSX there is little doubt that recognition by the UK authorities will boost the exchange’s image and with that will come more funds listing. Similarly, securities listed on the CSX are now regarded, by the UK authorities as qualifying investments – that is, the type of securities that are held directly in Personal Equity Plans [PEPs] and Individual Savings Accounts [ISAs].

Personal pension schemes can hold securities which are listed or dealt with on a recognised stock exchange. CSX is “already the leading offshore jurisdiction for structured finance issues.

There is no doubt that this recognition, following on from recognition by the London Stock Exchange, will integrate the Cayman Islands further into the European financial architecture,”notes CSX chairman, Anthony Travers, OBE. Integration is an important word for the myriad offshore exchanges which are keen to come in from the cold. The process of integration began during the last few years as initiatives by the Organisation for Economic Co-operation and Development [OECD] and the Financial Action Task Force [FATF] encouraged the Cayman Islands Government and other offshore regimes to ensure they stayed in line with internationally accepted standards regarding anti-money laundering measures. The process has been ongoing for years, was detailed, and ultimately successful as the Islands were removed from the FTAF blacklist back in 2001.

The FATF review process was of a technical rather than substantive nature – focusing on the nature of anti-money laundering regulations in place and the sanctions imposed under the regulations, rather than any policies or legislation already in place. The Islands were deemed to have complied with a level of regulations substantially in compliance with FATF recommendations and the Caribbean Financial Action Task Force recommendations. Since then, the Government has responded by making further amendments to the various pieces of anti-money laundering legislation.

“As far as CISX is concerned the recent round of recognitions achieved by the exchange from SEC/FSA/UK Inland Revenue coupled with the recent investment funds reforms in both Jersey and Guernsey aimed at capturing greater share of the alternative investment funds market means the CISX is bullish that it will continue to grow its

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U n i q u e l y

Established in 1971 the Bermuda Stock Exchange (BSX) is today the worldâ&#x20AC;&#x2122;s fastest growing offshore securities market.

p o s i t i o n e d

The BSX is internationally recognised as an attractive venue for the listing of: Hedge Funds Investment Fund Structures Equities Fixed Income Structures Derivative Warrants

Advantage Bermuda

www.bsx.com e-mail: info@bsx.com 22 Church Street, Hamilton HM 11, Bermuda Tel: 1-441-292-7212 â&#x20AC;˘ Fax: 1-441-296-1875

The BSX is a full member of the World Federation of Exchanges.

Bermuda is a British Overseas Dependent Territory and is part of the UK for the purpose of OECD membership.

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OFFSHORE EXCHANGES

number of fund listings,” says Simon Howard, Advocate at law firm Bailhache Labesse in Jersey. “Its flexible rule book and approach and its low listing fees have already won it a few fund listings from Dublin where funds have de-listed and moved to the CISX,”he adds.

In the capital markets area as well, says Howard, where Jersey in particular is a leader for securitisations there is a movement to use the CISX instead of European based exchanges: “on the basis that the CISX now has the necessary profile and recognition and it's on the doorstep. Also being close to Europe but outside EU listing and prospective requirements and directives means there may be opportunities for listing work for the CISX for issues which do not need to be compliant with this burgeoning area of EU regulation. For the foreseeable future the CISX will not compete head on with the main onshore European bourses.

But it is well placed to grow these niche areas of business.”

In the meantime, the Islands’ Financial Services Association has expressed support for the government’s decision to opt for exchange of banking information when the European Savings Tax Directive comes into force, scheduled for January 2005. Other jurisdictions, including the UK dependent territories of Jersey, Guernsey and the Isle of Man, have also opted to implement a transitional withholding tax on interest income for a period of

seven years before exchanging information with the tax authorities of EU member states. However, Switzerland remains aloof on the directive.“The Swiss government is maintaining the position of trying to link the savings tax agreement to other issues,” Internal Market Commissioner, Frits Bolkestein announced in a recent EU briefing, continuing: “The Commission and the Council [should] stick to their guns and ask Switzerland to sign an agreement without any further delay.”

However, according to local press reports, Swiss Foreign Minister Micheline Calmy-Rey said that Switzerland will be standing by the linking of the Savings Tax Directive with the signing of various other accords. However, several other third party countries [Liechtenstein, Andorra, San Marino and Monaco] have not yet signed deals with the EU, which is a precondition of the legislation coming into force in January next year. The UK government is set to announce that all of its dependent territories have agreed to comply by the rules of the European Savings Tax Directive, a report by news service Reuters has revealed.

A Treasury source told the agency: “This completes the process we began in 1997. We have not only stopped a damaging agreement to harmonise a withholding tax, but now all European businesses can enjoy a competitive and level playing field.”

Efficiency... that’s our stock in trade The CISX provides screen-based trading and the listing of investment funds, specialist debt instruments and shares in companies.

Our approach is highly personalised, offering fast-track processing of applications within a highly regulated and innovative marketplace.

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EU ACCESSION

Europe hangs in the balance. Euroland’s prosperity and growth is as much in the hands of outsiders as it is in the hands of Europeans themselves. Perhaps that’s why, on the eve of accession of ten more states, the European central bank is cautious about change. Angela Ward and Francesca Carnevale report.

J

UNE 2004 IS a watershed for European countries. Ten new members will have been admitted to an elite club of [mostly] rich nations. The world’s largest trading block will come into being, encompassing 455m people and 25 countries. Euro elections will have taken place in all of the countries, involving the election of some 732 members of the European parliament [MEPs]. It’s a staggering achievement – whatever your views of the confederation.

The economies of the new member states are still emerging and at the outset will add some 74m citizens and less than 5% to the current EU’s total output. However most of the entrants are recording growth rates well in excess of anything enjoyed by the original members [see Table 1: Macroeconomic data of the Accession Countries]. During 2003 GDP growth in the majority of central, east and southeast European countries even accelerated, according to the Vienna Institute for International Economic Studies [WIIW], despite near stagnation in the EU.

F T S E G L O B A L M A R K E T S • M AY / J U N E 2 0 0 4

That does not make for a particularly happy group of accession states however, as ongoing productivity improvements, particularly in industry, have been usually associated with cuts in employment. Unemployment is generally very high in most of the accession states. Poland’s unemployment rate is staggeringly near 20%, while the Slovak Republic ‘enjoys’ rates hovering near 15%. Estonia, Latvia and Lithuania are better off, showing 10% unemployment each, while Hungary’s figure – the best of the accession states, is 6% but threatening to rise. Even so, France’s 9.7% unemployment levels show no better indications than those of the acceding states.

Worse for everyone, perhaps, is that unemployment is unlikely to go down in the medium term. What this means is a continuation of a notable degree of political instability in the new member states even as they join an enlarged Europe. Certainly there are few guarantees that the original member states can absorb many more economic migrants.

Greece, for example, has had to absorb in excess of 750,000 economic migrants in recent years and this trend is rising, while Italy reports similar numbers.

Creation of ideal preconditions for membership of the EU and, at some point, the Eurozone, has meant continuing disenchantment with the measures employed by governments to get their countries in line with Maastricht.

Poland’s premier, Leszek Miller, for example, is the most

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EU ACCESSION

Czech Republic makes its debut

T

HE CZECH REPUBLIC is a mixed bag. The Czech National Bank – the central bank – has cut inflation, which dropped as low as 2.3% last year. Notable this year will be the ability of the Finance Ministry to launch the Republic’s first Eurobond – worth $1bn carrying a maturity of 10 years. The success of integration will depend not only on the ability of the Republic to absorb EU Structural Funds effectively, but also to achieve early adoption of the euro. This is not likely given the pressure on the national budget as key healthcare and pension reforms are not adopted as quickly as the government would like. The government of Vladimir Spidla is meanwhile under pressure having lost its parliamentary majority in early March.

Nonetheless, its central location, coupled with a multilingual workforce, could mean it will become the natural choice for many European companies to locate logistic and distribution centres, production and assembly plants, thinks Hilary McDowell, a partner in the Prague office of CMS Cameron McKenna. “Accession heralds an exciting time for both those already doing business in the Czech Republic and those looking at it as a new investment possibility,” she says.

The Republic will also be a magnet for foreign direct investment [FDI]. Already significant investments from Peugeot Citroën and Toyota have been agreed, and together they are now building a joint plant in Kolin, east of Prague. The ground was broken for the new venture in April 2002, with production due to start at the beginning of 2005. The plant is expected to manufacture 300,000 small cars a year, primarily for European markets. “Supporting investment into the Czech Republic is a government priority,” says industry and trade minister Milan Urban. According to Bank Austria Creditanstalt, the country’s stock market has been performing well recently – boosted by the performance of Komerˇcní Banka and Cesky Telecom. The sharp growth in turnover of Komerˇcní Bank is confirmed by its announcement of 55% growth in mortgage loans over the previous year. “The Czech Republic has seen an increase in productivity recently, after a long period of inactivity,” says George Swirski, a partner at Advent International and part of the firm’s central European team. “The country does not promote the entrepreneurial culture of some of its neighbours, instead there is more of an engineering base.”

recent casualty; he has already been forced to resign – both as leader of his party and as prime minister. The Czech Republic’s prime minister doesn’t look to be too far behind. As unpopular measures have been introduced in each of the acceding countries, governments have come under increasing criticism and strain. They have no other choice however, in order for the acceding states to meet the all important Maastricht criteria. Restructuring is vital too if acceding states can have any chance of moving from emerging market status to developed market status. The governments in these states then look ready to fall like proverbial nine-pins.

According to a recent study by the WIIW, the accession of

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Privatisation has not been easy. Cesky Telecom, the former Czech telecom monopoly is the last remaining central European telecoms operator without a strategic partner. The state still owns 51% of the company – although full privatisation is expected to begin later this year.

“This privatisation has been on the Prague Square by night table for a while,” says Alain Bourrier, portfolio manager for emerging Europe at Merrill Lynch Investment Managers. “It was abandoned in December last year and although the timing is still difficult, it will go ahead at some point.”

Another privatisation was abandoned at the beginning of March – the sale of 55% of Severoceske Doly, the largest brown coal mine in the country – as bids failed to reach the level expected. However, the National Property Fund of the Czech Republic is currently working through the shortlist for the privatisation of a 63% stake in Unipetrol, the oil and petrochemical group. It has selected three candidates – MOL Hungarian Oil and Gas, PKN Orlen of Poland and Royal Dutch/Shell – from an earlier list of six.

“The EU accession countries, such as the Czech Republic, are already very attractive and have seen large levels of foreign direct investment over the last 14 years and we are therefore unlikely to see a significant increase in investment as a direct result of EU accession,” says Iain Batty, head of CMC Cameron McKenna’s commercial group in CEE. “It will, however, mean that more organisations will look to do business with the new member states without directly investing in the country. For example, banks will have no need to invest directly/open offices, because they will be able to provide their services on a ‘freedom of services basis’.”

the eight central and eastern European countries will not have a marked effect on either the old or the new members in the immediate term. Most acceding countries will face temporarily higher inflation as a result of tax and tariff harmonisation and “an attendant increase in interest rates thus cannot be excluded. Budget deficits may go up as well.”

Additional expansion of both exports and imports is likely, but not in equal measure and therefore the trade and current account deficits of the acceding countries will get worse before they get better. Foreign direct investment [FDI] flows are also unlikely to be enormous, as privatisation programmes are pretty much completed in all the accession states.

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Politically, Europe now becomes a patchwork of alliances and strategic preferences; a fact which will dominate press headlines for the foreseeable future. Poland will align with Germany, Spain’s new socialist government too looks to be tending the same way. How this will evolve over the coming decade is anyone’s guess. This will be particularly important when the EU tries to impose rules and regulations on incoming members – particularly when existing members don’t often do what they are supposed to. The EU executive commission has consistently failed to tackle or introduce changes to the Stability and Growth Pact [SGP] despite repeated breaches of its provisions by Germany and France and criticism that it can restrict economic momentum. The commission repeatedly warns that because of slower than projected growth Germany might again fail to respect the pact in 2005.

The controversial 1997 pact notably commits the 12 EU members using the Euro to hold annual public deficits to no more than 3% of output and government debt to 60% of gross domestic product. Germany and France, have repeatedly over-shot the three percent limit, which has been criticised by some commentators and commission members as imposing unrealistic constraints on growth and economic recovery prospects.

Whether there will emerge a tiered confederation where states in the Eurozone are either compliant or noncompliant with SGP; or refuse to enter it [the UK and Sweden for example] and those that want to be in it, but can’t get there for structural reasons, is anyone’s guess.

Equally no one is predicting how this patchwork of nations will move as one, when it counts.

So far, measures appear well-meaning, but remain short of the ideal. The Nice summit, meanwhile, is supposed to ground key operational issues such as voting formulas and budget procedures as well as laying down some key constitutional issues, such as guaranteeing human rights.

As we go to press, the leaders of all 25 states were/are

agreeing a new formula for weighted decision-making – which will, hopefully, take effect on accession.

Britain, France, Italy and Germany – the EU’s ‘Big Four’ powerbrokers have some 27 votes each in the enlarged Europe; although in the current discussions Germany could end up with more votes than anyone else. Poland and Spain brought to a halt last year’s talks on operational procedures and the constitution precisely because of this two vote advantage – which, the Big Four claimed, were a result of having much larger populations. Poland and Spain were awarded 25 votes each – which didn’t make much difference at the time. But now things have changed. Spain has moved noticeably towards the centrist position in Europe after the election of the socialist government of José Luis Zapatero who stated that Spain was ready to compromise to get a new constitution underway. The new Europeans have until 18 June to sort it all out.

The movement of a customs union to a fully coordinated confederation [or even full federation] will only come in fits and starts. The move to a more unified political and economic marketplace will only accelerate if there are deemed to be sufficiently threatening events taking place inside or outside the EU that will require cohesive actions. It’s what Giscard d’Estaing slyly refers to as a ‘Philadelphia moment’.The recent development in the emergence of Europe’s new constitution is testament to that thinking: it will not go away – whatever the geopolitical strains on the union.

The tragedy of the Madrid bombing has crystallised thinking – as threatening events always do – for procentrists who are keen on a formal constitution. For the 10 accession states, constitutional legislation is not regarded – except by Poland – as any kind of problem; but rather an important supplement to emergent liberalising laws in their own countries. For established members, it’s a different issue – one of overriding centuries of established constitutional practice. The imposition of a common defence policy, common taxation and the incorporation of

Table 1: Macro economic data of EU Accession countries 2003-2005

Country/Year Cyprus Czech Republic Estonia Hungary Latvia Lithuania Malta Poland Slovak Republic Slovenia

GDP GDP GDP % % % Growth Growth Growth [est] 2003 2004 2005 2.0 2.9 4.4 2.9 7.2 8.9 0.8 3.7 4.2 2.1

3.4 2.6 5.6 3.2 5.2 5.7 2.7 4.2 4.1 3.1

n/a 4.0 5.1 3.9 5.7 6.0 n/a 4.0 5.0 3.5

CPI %

CPI %

2003

2004

4.3 0 1.6 5.7 3.6 -1.2 1.3 0.7 8.5 4.6

2.1 3.3 3.9 6.1 3 2.3 1.8 1.9 8.2 5.2

CP C/A C/A Budget Budget Public Public % Deficit Deficit Deficit Deficit Debt Debt % of % of % of % of % of % of GDP GDP GDP GDP GDP GDP 2005 2003 2004 2003 2004 2003 2004 n/a 2.0 4.0 5.0 3.0 3.0 n/a 5.0 5.0 3.5

-4.4 -6.6 -15.2 -6.2 -9.0 -6.0 -6.6 -2.9 -3.8 0.5

-3.1 -6.9 -12.2 -6.1 -9.5 -5.8 -6.3 -3.4 -4.4 0.3

-6.0 -12.9 0 -5.9 -2.7 -1.7 -9.7 -4.3 -5.1 -2.2

-3.7 -3.7 -0.4 -4.4 -2.7 -3.1 -5.8 -5.9 -4.0 -1.8

63.5 30.7 5.4 57.9 16.7 21.3 72.0 45.1 45.1 27.4

62.6 34.5 5.3 56.9 18.2 23.6 69.4 49.2 45.2 27.0

Source: EFG Eurobank, Athens, March 2004 and the Vienna Institute for International Economic Studies 2003.

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a charter of fundamental human rights will cut to the core of legislation in the original founding countries – even if individual premiers say it will not.

Nonetheless, the expansion of Europe calls for serious reflection of the role of, in UK premier Tony Blair’s words:“an

emergent super-power,”– though he was quick to qualify his statement with “but not a superstate.”Even as enlargement unfolds, its members must reflect on the responsibilities it must assume in and beyond the continent. Across the Mediterranean especially, an extraordinarily dangerous

Poland: Popularity isn’t everything

E

UROPE IS POPULAR in Poland. In June 2003, 77% of Polish electorates voted in favour of joining the EU: “Poland has taken a huge historic step,” said Polish Prime Minister, Leszek Miller, prior to his resignation in late March, reports Angela May Ward.

Poland, in turn, is also popular with investors. According to the FDI 2003 Confidence Index conducted by AT Kearney, Poland was named as the fourth most preferred investment destination worldwide – ahead of China, the US and Mexico – and up from 11th place the previous year. “Progress on economic reforms, EU accession and building on existing high levels of investor confidence will help Poland to move beyond lower-cost manufacturing towards increasing amounts of foreign direct investment in the high-skilled service sector,” says Andrzej Zdebski, president of the Polish Information and Foreign Investment Agency.

The dream is not without its problems. The country meanwhile lost out to Slovakia in the awarding of Hyundai’s new car assembly plant. Similarly, last year PSA PeugeotCitroën chose Slovakia over Poland for its new factory. Where Poland does score over its neighbours is in the sheer size of its market. With 38m people, Poland represents 50% of the population of all the ten accession countries.

Consumer spending meanwhile has been growing steadily, spurring the country’s growth over the last three years. “With rising consumer demand, expect to see an initial wave of heightened acquisition activity for perhaps the first year,” says Janusz Heath, managing director and head of central and eastern European private equity at Dresdner Kleinwort Capital.

“The Warsaw Stock Exchange will probably benefit most from this, as the other exchanges have very limited liquidity.” At present the Warsaw Stock Exchange’s [WSE’s] equity market capitalisation exceeds Euro30bn and there are 203 companies listed on the exchange, along with 60 bond issues. It is also attracting attention from foreign companies, with Bank of Austria Creditanstalt gaining a listing on the exchange last October.

“Poland’s accession to the EU will bring a period of increased interest from foreign investors,” says Monika Matlak, international relations, WSE. “For the exchange, the accession and harmonisation of Polish regulations with EU regulations will mean more opportunities to attract new customers. The medium-term strategic goals of the WSE are strengthening of the Polish capital market and shaping favourable relations with European exchanges. The envisaged privatisation of the Exchange would enable better positioning of the WSE on the wider European market. This would be achieved through making it an important element of the European network – the trading platform for securities listed in the CEE region.”

According to Bank Austria Creditanstalt, the Polish government’s inability to rally sufficient support in parliament is resulting in the gradual dilution of the austerity programme put forward by the Minister of Economics, Jerzy Hausner.

Significant cuts in social welfare spending are required in order to reduce Poland’s widening budget deficit – which is estimated at just below 6% of GDP this year to 3% of GDP and below Monument of Jan III Sobieski, Warsaw as required by the Maastricht Treaty for euro conversion, according to the research team at Eurobank in Athens. The approval of the first of three reform packages under the Hausner plan in mid-March boosted the zloty from record lows of 4.9430 to the Euro at the beginning of March, but fiscal reform appears far from over.

In the meantime, privatisation in Poland hasn’t been driven forward as quickly as neighbouring countries. “It seems that successive Polish governments have all been quite nationalistic and cautious about the privatisation process – so there is still some potential for more privatisations in the future,” says Alain Bourrier, portfolio manager for emerging Europe at Merrill Lynch Investment Managers. Adds Janusz Heath: “As with all countries, privatisation is politically sensitive, particularly when related to infrastructure assets even though the state is illequipped to finance modernisation.”

Among key recent privatisations was the sale of the steel company Polskie Huty Stali to LNM Group – an important step in the Polish iron and steel restructuring programme.

Privatisations expected this year – which are all planned through the WSE – include PKO BP [banking sector], Enea [energy], Poludniowy Koncern Energetyczny [energy], Ciech [chemicals], WsiP [media], Polmos Bialystok [food industry] and Zelmer [household equipment]. George Swirski says Poland stands out from its neighbours in its entrepreneurial culture. “Since we entered the region in 1994, we have seen a lot of companies develop from one-man-bands into quite sizeable concerns,” he says. “And I think this activity has been a real driver for the Polish economy.”

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stalemate in the Middle East will demand more European involvement than has been the case during the past year. In Europe, too, more EU leadership will be expected when attending to unfinished business in the Balkans and in revisiting the Western approach to Russia. The year ahead is not easy. The ‘wrong’ call on Turkey could either unbalance the union [according to the Belgians]; or create an unfriendly bulwark on the margins [according to the Greeks]. As Phaedon Tamvakakis, managing director of Alpha Trust in Athens proclaims: “At least they can’t blame this one on us.”

For core EU’s members, however, the priority in this accession period is more prosaic. They have to find ways to kick start growth once more.

Euro growth lags significantly behind the US as the positive effect of global growth on external demand in the Euro area is counterbalanced by deterioration in price competitiveness due to the continued appreciation of the Euro, says Paul Mylonas, head of research at the National Bank of Greece. Nonetheless, business export expectations remain upbeat, “though that will depend on the capacity to continue cost cutting or improving productivity,”says Mylonas.

Any immediate intervention by the European Central Bank [ECB] in this regard is unlikely. The monetary strategy of the euro area, historically, has not targeted exchange rates, even though the central bank’s Governing Council claims to closely monitor the exchange rate. Additionally, European central bank thinking favours low interest rates, and the strong euro maintains the status quo while demand looks like picking up and liquidity remains in the market. Greg Weldon, of Weldon’s Money Monitor in the US, says: “The ECB needs to join the monetary party, and focus on growth, rather than waiting for inflation in peripheral satellites to decline further. In fact, as revealed in a recent Money Monitor, Portuguese and Spanish CPI rates have fallen significantly over the last 12 months, and the prior 12 months, to levels that used to define core European CPI rates. The market is, finally, after months, if not years, of pricing in a persistently hawkish monetary policy from the ECB now beginning to price in a rate cut.”

Pressure on the ECB to act also comes from indigenous quarters. Influential German think-tank Institut für Wirtschaftsforschung [Ifo] is calling for a cut in Eurozone interest rates following indications that Germany’s recovery is in trouble. As it did in February this year the latest Ifo Business Climate Index of manufacturing, construction, retailing and wholesaling in Germany fell in March.

Expectations for the next six months have also worsened. Of particular concern is the indicator of the current business situation, which has declined for the first time in six months.

Whether or not the ECB will bow to pressure to cut rates further remains to be seen. Keeping inflation below a target of 2% is the central bank’s strategy. What this means is that the tough going in the Euro heartland will continue.

“In the wake of accelerating growth in the USA and Asia, world trade is returning to considerably higher growth rates.

External demand has been the main factor behind the initial signs of improving economic activity in the Euro area,” Deutsche Bundesbank president, Ernst Welteke, in a recent speech to the British Chamber of Commerce. For any export driven recovery in Europe to lead to self-sustaining expansion, domestic demand needs to pick up – by both consumers and investors. Throughout Europe, there are signs however that consumer demand is stabilising and at lower than anticipated levels. Initial figures released by the EU in early March shows economic growth in the 12 nation core states will pick up to a measly 0.4% to 0.7% in the first half of 2004, after a“sluggish”0.4% performance last year. It’s not great news. Through 2003, the ECB had trumpeted growth close to the top end of a 1.1% to 2.1% range, with an upswing to 2.9% in 2005. A weak job market and insecurity over pension provision are some of the issues cited by financiers that are weighing heavily on consumers in particular. “All markets will be rough through 2004 and 2005,”says Mylonas, director of research and chief economist of the National Bank of Greece. “We’re living in a strange world where all markets are over-valued. Once the US decides to take away liquidity we’ll all have it rough. In that context, I think there will be a flight to quality.”

The relative performance of the FTSE Hungary, Poland and Czech Republic indices

The relative performance of the FTSE New EU Index and the FTSE Eurobloc Index [Large/Mid Cap] 150

FTSE New EU Index

140

FTSE Eurobloc Index [Large/Mid Cap]

160

150 130 140

Rebased values

Rebased values

120

130

120

110

100

90 110 80 100

70

60 Dec01

90 Mar03

Apr03

May03

Jun03

Jul03

Aug03

Sep03

Oct03

Nov03

Dec03

Jan04

Feb04

Mar04

Date FTSE Hungary

FTSE Poland

FTSE Czech Republic

[all indices are Large/Mid Cap]

FTSE GLOBAL MARKETS • MAY/JUNE 2004

Source: FTSE

Mar02

Jun02

Sep02

Dec02

Mar03

Jun03

Sep03

Dec03

Mar04

Date

The FTSE New EU Index covers the markets of the ten accession countries due to join the European Union on May 4, 2004. Full details including a constituent list are available from www.ftse.com/neweu Source FTSE

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EU ACCESSION

Table Two: A Quick Guide to the Accession States CYPRUS – Moody’s A2/S&P A/Fitch A+ Capital: Nicosia.

Currency: Cyprus Pound. Main imports include consumer goods, petroleum and lubricants, food, grains and machinery.

Main exports include citrus fruits, potatoes, grapes, wine and cement. Cyprus has been divided since 1974. Reunification talks are unlikely to be finalised by 1 May. The budget deficit to GDP ratio has risen to 6%, but the government says it will fall back to 2.2% in 2006 – Cyprus is the third largest island in the Mediterranean sea, south of Turkey. Longer term outlook: Will invariably end up in competition with Greece and Turkey over the establishment of a regional financial centre that dominates the Balkan region and eastern Mediterranean – particularly as Israel’s economic power could decline over the coming decade.

HUNGARY – Moody’s A1/S&P A-/Fitch A- Capital: Budapest.

Currency: Forint. Main exports include machinery and transport equipment, foodstuffs and chemicals. Main imports include machinery, fuels, food and raw materials. Accelerating inflation and the highest interest rates in Europe [12.5%] overshadows a good economic performance. Big spending cuts have been introduced by the government, anxious to meet this year’s target of a 4.6% deficit/GDP ratio. Fitch warns of a possible downgrade. Long term outlook: With the Czech Republic, Hungary has the most visible and positive of images of the 10 accession states. It’s unlikely though that it will adopt the Euro much before 2009, if at all by then.

MALTA – Ratings not available. Capital: Valletta, Currency: Maltese lira. A widening budget deficit, now equal to 9.7% of GDP, while its debt is a whopping 72%. Long term outlook: A relatively cheap, but well educated workforce could encourage added value technology industry and special interest tourism.

Will always be niche and dependent on tourism.

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LATVIA – Moody’s A1/S&P A-/Fitch A- Capital city: Riga Currency: Lat. Main exports are timber, wood products, fish and fish products. Main imports are machinery and equipment, chemicals, fuels and vehicles. Inflation is rising because of strong domestic demand. Economic growth remains good, reaching 7.2% last year, but there will be a widening of the C/A deficit. Will issue a €400m 10 year Eurobond in March. Long term outlook: Huge potential is undermined by continuing political instability as the right wing coalition is losing its majority.

POLAND – Moody’s A2/S&P BBB+/Fitch BBB+ Capital: Warsaw, Currency: Zloty. Main exports are machinery and transport equipment, foodstuffs and chemicals. Main exports are chemicals, machinery and manufactured goods. Public finance reform is the biggest challenge. A widening budget deficit is forcing a new austerity programme [Hauser plan]. Short term instability is likely because of an increasingly unpopular government/premier. On accession a new premier will be installed; namely Finance Minister Belka. Long term outlook: Is the largest of the accession states and the most likely to benefit from membership over the long term.

A new privatisation strategy has been announced.

CZECH REPUBLIC – No ratings information available. Capital: Prague. Currency: Koruna. Main exports include manufactured goods, machinery, cars, transport equipment and beer.

Imports are mainly machinery, fuels and chemicals. A mixed cocktail. Inflation is down to 2.3%, but fiscal deficit is still very high, reaching a record 12.9% in 2003. The economy grew 2.9% last year. The Republic will issue its first Eurobond [worth $1bn] this year, with a 10 year maturity. Pension and healthcare reform are a priority. Long term outlook: A tough call, as political instability may undercut positive reform efforts and postpone Euro adoption.

SLOVENIA – Moody’s Aa3/S&P A+/Fitch A+ Capital: Ljubljana, Currency: Tolar. Exports machinery and transport equipment.

Imports machinery, fuels, lubricants and food. Inflation is coming down and a recent rate cut by the central bank has brought IR down to 5.5%. New budget sees a deficit of 1.7% of GDP, well below Maastricht’s 3% barrier. Looking to enter Euro by 2007.

Long term outlook: Will probably do better than expected.

LITHUANIA – Moody’s A3/S&P A-/Fitch BBB+ Capital: Vilnius, Currency: Litas. Main exports are mineral products, clothing, fertilizers and industrial machinery. Main imports are mineral products, machinery and equipment, textiles and clothing.

Strong growth of 8.9% last year pushed up ratings. Debt to GDP fairly low at 23%. It increased its 4.5% 2013 Eurobond by €600m to €1bn on February 29, at a spread of 46.5 basis points over the Bund 2013 benchmark, thereby setting a new benchmark in its yield curve Long term outlook: Some local instability because of possible government corruption.

ESTONIA – Moody’s A1/S&P A-/Fitch A- Capital: Tallinn.

Currency: Kroon. Main exports are machinery, textiles and wood products. Main imports include machinery and equipment, chemical products, textiles, foodstuffs and metals. Very low debt to GDP ratio. Robust growth driven by consumption, with an attendant rise in bank lending, a widening trade deficit and a high current account deficit. Makes strenuous efforts to meet convergence standards. Needs to boost exports and attract more foreign investment. Has very low public debt. Longer term outlook: Needs to establish a more robust identity in an enlarged Europe.

SLOVAKIA – Moody’s A3/S&P BBB+/Fitch BBB+. Capital: Bratislava, Currency: Koruna. Main exports include manufactured goods, machinery and transport equipment. Main imports are electrical machinery, transport equipment, furniture, manufactured goods and chemicals. Good export performance and growth rates and an increasingly attractive country for FDI. Hyundai leading foreign investment. The Koruna is rising in value and Euro adoption by 2006 is on the agenda. Long term: Is beating Poland and Hungary at their own game. May become too successful and there will be upward pressure on inflation and wages, but in the medium term, the country’s outlook is very good.

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Hungary prepares for accession

W

HEN HUNGARY HELD its referendum about joining the EU, some 84% voted in favour and, today, professionals and business people are being bombarded with information about what EU accession will mean. “Despite all this information, it is difficult to draw a precise conclusion as to the impact it will have for the country as a whole,” says Gabriella Ormai, who heads up law firm CMC Cameron McKenna’s practice in Budapest. “But, I imagine there will be both benefits and challenges across a number of industries.”

The main concern in Hungary currently is its turbulent economic situation but the government, led by Péter Medgyessy, is hoping it has turned the corner with the appointment of a new finance minister – Tibor Draskovics. He has been brought in to replace Csaba Laszlo, who was dismissed after the 2003 deficit was higher than the finance ministry had predicted.

Since his appointment Draskovics has taken an active role in pushing the economy in the right direction, but admitted recently that a considerable public finances deficit and a balance of payment deficit had accumulated in recent years.

“The current short-term task of our economic policy is to reduce this balance deficit to a size that does not restrict opportunities for growth,” he says.

Draskovics has already said that reform is necessary across the Hungarian state sector – particularly hospitals, schools, government ministries and public sector agencies. Since the collapse of communism in 1989, he explained, sectors such as banking and pharmaceuticals have already been radically overhauled by private investors.

“Once the country began opening up to foreign investment, Hungary made a real push to attract large corporate investors such as General Electric,” says George Swirski, a partner at Advent International and a member of the firm’s Central European team. “The country has also fostered a more valueadded high-tech culture than some of its neighbours. And, despite the worries of the budget deficits which have frightened investors, industrial production is still rising by double-digit growth.”

The Budapest Stock Exchange [BSE] is getting ready for EU accession by adapting rules and regulations which are 100% EU compliant, while the Hungarian Capital Act – which will come into force on 1 May this year – is based on EU principles. In addition, the Exchange has just published its corporate governance recommendations and these apply the same set of standards as anywhere in the EU. “Changes are essential for the development of the Hungarian capital market,” says Gábor Kutas, head of business development and communication for the BSE. “Being a member of the ‘club’, we are ready to play by its rules. The BSE has risen more than 30% since December 2003.”

“The Hungarian market has been rather undervalued,” Kutas adds. “But, blue-chips in Budapest are doing extremely well and the underlying performance of the individual

FTSE GLOBAL MARKETS • MAY/JUNE 2004

companies show strength, dynamism and, hopefully, a great future.

Despite the macro difficulties – investors seem confident in holding Hungarian equities.”

The BSE has set up the Club of Quotables – which gives companies preparing to go public advice. “The BSE board considers an increase in the number of issuers and the listing of new companies on the market its most important priorities,” explains Chain Bridge, Lánchid, Budapest Kutas. “We have also created a forum for club members to meet each other, as well as other market players – such as analysts and institutional investors.”

Compared with its neighbours, Hungary’s privatisation process has been quite rapid. “Hungary chose the method of market-based privatisation, rather than the quicker and more popular voucher system applied by other countries – which has proven to be questionable in terms of efficiency,” says a spokesperson for the Hungarian Privatisation and State Holding Company. There is still likely to be some privatisation activity this year, including a further decrease in the state’s holding in the oil and gas group MOL, a secondary offering in the pharmaceuticals company Richter Gedeon, a potential sale of the National Lottery, and the possible privatisation of the National Post.

In terms of sectors that look attractive to investors, Alain Bourrier, portfolio manager for emerging Europe at Merrill Lynch Investment Managers, says that banking is at the top of many lists. “The retail banking market is just emerging in countries like Hungary,” he says. “There is a growing demand for products like loans and mortgages and this can only continue.” Up to September 2003, Germany accounted for the highest proportion of investments in Hungary [24%], followed by the US [14%], France [9%], Austria [5%] and Belgium [5%]. In addition, share offerings through international capital markets accounted for some 30%.

“Within the accession countries, some regions – for example the greater Vienna-Bratislava-Budapest area – have the potential to become highly prosperous, even by western European standards, as they offer investors a skilled and educated workforce and developed – and still improving – transport and warehousing infrastructures,” says Peter Köves, managing partner of the Budapest office of Clifford Chance.

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GREECE

Greece is a tale of two countries. It enjoys some of highest levels of economic growth in Europe but there’s been a dramatic decline in living standards for broad layers of the population. This duality impinges on both the incoming government and established investment institutions in-country. They are pulled as well, by twin urges to tackle problems at home while simultaneously trying to establish Greece as a thriving regional financial centre. Can they succeed? Francesca Carnevale reports from Athens.

Myriad faces OF a new Greece REECE’S INCOMING NEW Democracy Party [ND] government is eager, says Marina Vassilicos, manager of international affairs at the Association of Greek Institutional Investors: “keen and theoretically very well prepared.”It needs to be. ND has inherited one of the fastest growing economies in Europe. It will have to work hard though to maintain growth rates of 4% and more a year – especially given the structural shifts that are taking place, both in Europe and in-country.

Greece’s stock markets reacted to the right wing victory of Konstantin Karamanlis by rising to a two-year high.

“We’ve seen a significant rally since the beginning of the year and price/earnings ratios [P/Es] still look fair,” adds Vassilicos. The upward trend in Greece’s stock market can be traced to March 2003. Last year the Athens Stock Exchange returned 8.1%, according to Datastream and the National Bank of Greece [NBG], compared with 6.6% in the Eurozone and 3.1% in the US. “Greek stocks are somewhat more expensive than European listed firms, though cheaper than US listed firms,” explains Paul Mylonas, head of research and chief economist at NBG.

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SPONSORED STATEMENT

The Athens Exchange (ATHEX)

Investment Opportunities in a

Dynamic Economy

Positive Macro Environment for Listed Companies Greece has undergone a major economic transformation. Over the past six years, the country's average annual GDP growth rate of 4%, has constantly outperformed other European Union member countries respective growth rates. Economic prospects remain excellent.

The country’s impressive infrastructure improvement program, the positive effect of hosting the 2004 Olympic Games, liberalization of the markets and intensive privatization of state enterprises combine to provide a significant long-term boost for investment in Greek capital market-listed companies with proven records of dynamic growth and sound fundamentals.

Athens Exchange - Safe, Reliable, Transparent The Athens Exchange (ATHEX) - now fully privatized and owned by Hellenic Exchanges S.A. – is committed to offering investors a safe, reliable and transparent market for investments.

Recent developments in the Greek capital market have concentrated on strengthening the regulatory framework placing particular emphasis on sound company accounting, raising the standards of corporate governance, company disclosure, the introduction of codes of conduct for companies, the continuous upgrade of the technical infrastructure and the implementation of a real-time surveillance system.

The focus is on safeguarding and further improving investor protection and confidence by enhancing market transparency and on introducing innovative products as market needs dictate. These development reinforce the ATHEX reputation as a competitive exchange, fully integrated with mature capital markets and trusted by foreign investors who currently hold more than 30% of market capitalization.

Investment Opportunities ATHEX’s dedication to continuous improvement, the development of distinctive products and sound economic prospects in Greece combine to form favorable conditions for the global investor seeking new investment opportunities.

Products offered on the ATHEX include: cash market stocks of industrial, financial and other service sector companies; corporate bonds; state bonds; index and stock futures and options; stock repos; reverse stock repos; currency (EUR/USD) futures.

Conclusively, the Greek capital market - with a positive macro environment, liquid stocks and market makers supplying liquidity in a range of cash and derivative products - remains an excellent investment opportunity for a well planned portfolio.

Detailed information on the cash market, the derivatives market and the macro environment of ATHEX can be found in the specially-designed ATHEX websites: www.ase.gr, www.adex.ase.gr and www.invest-in-gcm.com

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GREECE Fokion Karavias, Treasurer at EFG Eurobank

“Construction, for example, is a driving force in the economy, contributing around 15% to GDP. At the end of this year, this will change.”

Greece’s story is of a country with two faces. While it enjoys some of the best growth rates in the EU, at 10%, Greece’s unemployment level is also the highest in the Eurozone. The country has approximately 4m workers, but there are structural issues at play. Young people and women are the hardest hit. Unemployment is compounded by the influx of around three quarters of a million economic migrants. Many of these work for low pay and, at the lower end of the economy, continue to exert downward pressures on wages for everyone else. More pertinently, migrants often work in the black market. Fokion Karavias, treasurer at EFG Eurobank, says the black market is currently worth between 20% to 25% of Greece’s GDP. It is revenue that the ND is increasingly eager to fold into the real market.

Nonetheless, rapid output growth rates between 1997 and 2003 have helped reduce the income gap between Greece and the rest of Europe by:“some 9 percentage points to an estimated 75% of Euro area per capita income, at end - 2003”according to NBG economic and market analysis.

Having inherited a fair economic wind, the new government can promise only more of the same – only better and faster. In his debut speech in late March to parliament as ND’s Economy Minister, Giorgos Alogoskoufis outlined policies very similar to those of the outgoing socialist PASOK government: growth rates of 5% and more each year, higher employment – up to 60% from the 56.7% it is now – and convergence of wages and pensions in line with other, more advanced, European economies. A lot hinges on the impending audit ND intends to undertake prior to making any promises that leave them open to criticism. Some bet hedging has already begun.

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The outgoing PASOK administration wasn’t too concerned about accurate reporting of the country’s accounts says Alogoskoufis. For example, the 2003 budget will show a deficit equal to 2.7% of the country’s GDP instead of the originally forecast of 1.4% and 2003’s GDP growth was 4.2 % not 5%.

“He knows the government has the proverbial Sword of Damocles hanging over it,” says NBG’s Paul Mylonas. The government faces Euro-elections in June; the ongoing Cyprus question, the Olympics and presidential elections next year: “that’s a lot of opportunity for the electorate to make things difficult for them in implementing necessary but unpopular measures. The closer the budget deficit is to 3% and above, the tougher the measures will have to be.

That’s why they are keen to do an audit – to find out what they have to do.”

Platon Monokroussos, head of economic research at EFG Eurobank sounds an equally cautionary note: “Economic prospects for the next two years remain sound, but our growth forecasts for 2005-2006 are slightly more downbeat.”Monokroussos cites three reasons: a decline in the competitiveness of Greek exports; a fall off in the level of growth of private consumption as disposal incomes erode; and finally, the government will have to target lower deficits and higher primary surpluses to reduce debt reduction. Essentially, Athens’ analysts boil their thinking down to the following premises: higher levels of investment, a number of structural reforms and a willingness to adopt international best practices have raised the potential growth of the economy. Other factors at play in the country’s growth however are demand-led and could dissipate rapidly. Monokroussos explains: “It’s a very important concern. Construction, for example, is a driving force in the economy, contributing around 15% to GDP. At the end of this year, this will change.”

Greece’s corporate structure is still dominated by smaller family owned businesses. Consolidation of these companies; the emergence of new, strong brands is required: “It may be a generational thing,” says NBG’s Mylonas.“It will take time and effort to change this way of thinking and operating.”

Phaedon Tamvakakis, managing director of Alpha Trust Investment Services, Greece’s oldest and largest private investment fund, sees a gradual emergence of new, improved Greek entrepreneurship. Tamvakakis thinks that the emergence of a significant M&A market in Greece is still some way off. There may be room for consolidation among the family owned companies, he says, but he thinks the important issue is companies coming to the fore on their own steam. “We see increasingly companies such as Follie Folly, the Greek luxury goods brand, making an impact internationally. It’s a healthy sign and others can follow.”

Last year however, in a fractal of the broader trend, Alpha Trust’s investment portfolio, which does not invest in indices but prefers to buy shares in dominant companies in a sector, favoured banks. According to Tamvakakis Alpha Trust prefers to put its money “where there are unique characters.

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Normally we find sectors that have gone past severe at their own game, both in the country’s lucrative consumer competition are more relevant to us and more profitable. credit market in Greece and in the wider Balkans region, few are openly coming out and saying it. General Bank We’ll always try to pick the strongest performers.”

Here too is the issue of the structure of Greece’s financial politely declined to be interviewed for this article, with the markets. Among the leading companies in the stock proviso:“We need to work out with the French what will be market, for example, are the country’s big banking groups. done first.”

Like General Bank and NBG, EFG According to Marina Vassilicos, Eurobank is keen on seeing Greece as “there is still room for a regional centre. It’s a goal which rationalisation in the banks. But Greece’s banks particularly hanker for. fundamentals are getting better and In part, says Karavias, it is natural accounting requirements for listed expansion. Eurobank, like others, he firms are more stringent and will be explains has already bought banks and in IAS form as of 2005.” market share in Bulgaria and Romania.

Explains Marina Vassilicos, the Equally important, is the realisation impact of listing also on the US that the good times in Greek banking exchanges is forcing through change can’t carry on for evermore. If it’s not thoughout corporate Greece, with competition from foreign banks, there positive effects all around: “there’s a are other concerns. Competition from new generation of managers who foreign banks may be an issue. But are highly educated and are Greek banks have also seen foreign experienced with international banks come in before – Barclays, ABN markets and requirements.”

AMRO, Bank of America and HSBC. One sector under the spotlight is Equally, they’ve seen banks leave: banking, which is a sector ripe for “even Citibank downsized their change in the new, enlarged business here. The reason: Greek Europe. After a period in which banks have a strategic dominance in foreign banks, such as Barclays and the country’s retail business. The others transferred their foreign largest four or five banks have 80% of exchange operations back to the Phaedon Tamvakakis is Managing Director of the market. It’s a tough one to enter. centre in London, other European Alpha Trust Investment Services General Bank probably has around 2% banks are now looking for a foothold in the market – sometimes as a launching pad for of the market – so we’re interested to see what Société an assault on the greater Balkans region. It is in the Générale will do,”says Karavias.

General Bank is an interesting case. It used to be a banking sector too, that after a shaky start, Greece’s privatisation programme is gradually coming back on track. corporate financing bank, with some 85% of its lending Société Générale [SG], France’s third largest bank won the directed at medium-sized companies. In 2000, General tender for a 22.34% stake in General Bank for some €6 per Bank’s management decided to enter the retail segment, share in March. General Bank is now expecting a further now the ratio of corporate to retail lending at the bank is reportedly close to 70%/30%. share capital increase from It is thought that Société SG that will make it the It is in the banking sector too, that Générale will aim for General majority shareholder. The after a shaky start, Greece’s privatisation Bank to achieve 5% of the Army Pension Fund retains a market within two years.

10% share and three seats on programme is gradually coming back But, EFG Eurobank the board of directors. on track. treasurer Karavias says: In other initiatives in the “while we expect the rate of privatisation programme, the government will also transfer 2% of its shares in NBG consumer expansion to contract, it is unlikely to be to the Social Security Foundation [IKA] – the country’s dramatic. Total consumer credit as a proportion of GDP is largest public pension organisation. The State now still only 65%, compared with the average Eurozone ratio controls a mere 7.5% of NBG, institutional investors hold of 100% and above. There’s still leeway. As well, the 20%, foreign investors slightly less [18%] and local mortgage market too is not overleveraged, so we don’t see bubbles bursting.“ pension funds own 17%.

The outward drive though is a counterpoint to two It’s important to get the banks on the right footing if they are to compete effectively in the new Europe. Government important longer term developments. First is the need to management doesn’t sit easily side by side in a market counterbalance centrist tendencies within the EU which is still tailored to the retail user. But if new banking hierarchy. Second,“Greek banks are still grounded in retail groups are coming in wanting to take on the Greek banks business. That’s not an issue in the medium term. From

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